ASSESSING THE QUALITY OF A SECURITY MARKET - A NEW APPROACH TO TRANSACTION-COST MEASUREMENT

I discuss a new method for measuring the deviations between actual tra nsaction prices and implicit efficient prices. The approach decomposes security transaction prices into random-walk and stationary component s. The random-walk component may be identified with the efficient pric e. The stationary component, the difference between the efficient pric e and the actual transaction price, is termed the pricing error. Its d ispersion is a natural measure of market quality. I describe practical strategies for estimating these quantities. For a sample of NYSE stoc ks, the average pricing error standard deviation estimate is roughly 0 .33 percent of the stock price. If the pricing error is normally distr ibuted and if it is always a positive cost incurred by the transaction initiators, the corresponding average transition cost for these trade rs is 0.26 percent of the stock price. The dispersion of the pricing e rror is also found to be elevated at the beginning and end of the trad ing session.