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How Reliable Are Adverse Selection Models of the Bid-ask Spread?Robert Neal |
ABSTRACT Theoretical models of the adverse selection component of bid-asked spreads predict the component arises from asymmetric information about a firm's fundamental value. We test this prediction using two well known models [Glosten and Harris (1988) and George, Kaul, and Nimalendran (1991)] to estimate the adverse selection component for closed-end funds. Closed-end funds hold diversified portfolios and report their net asset values on a weekly basis. Thus, there should be little uncertainty about their fundamental values and their adverse selection components should be minimal. Estimates of the component from the two models, however, average 19 and 52 percent of the spread. These estimates, while smaller than corresponding estimates from common stocks, are large enough to raise doubts about the reliability of these models. Robert Neal is an economist at the Federal Reserve Bank of Kansas City. Simon Wheatley is an assistant professor of finance at the Australian Graduate School of Management, University of New South Wales. The authors wish to thank Cathy Bonser-Neal, Avi Kamara, Charles Lee, Jon Karpoff, Tom Miller, Pegaret Pilcher, Jeff Pontiff, and seminar participants at the University of Colorado, the Federal Reserve Bank of Kansas City, the University of Maryland, the University of Memphis, the University of Notre Dame, the Securities and Exchange Commission, and the University of Washington. The views expressed herein are solely those of the authors and do not necessarily reflect the views of the Federal Reserve Bank of Kansas City or the Federal Reserve System.Back to top RWP home |