Today the financial market becomes more complex and includes more competition.
Reasons are trends like globalization, liberalization and lower-cost trading
mechanism. The market microstructure research has the aim of an efficient market. It
is focused on the structure of the financial market. The investigation becomes
possible through the availability of high- frequency data. Those data exist especially
in the United States and like that most of the research focuses this market. To explain
the phenomena, which have been found adequate, models that fit the characteristics
of high- frequency data have to be developed.
The research is important to understand actions on the market as well as develop new
efficient mechanism. One part of the market microstructure field is the bid-ask
spread. It will be focus of this paper. In the first two parts it will be discussed
theoretically. In the last part one model will be empirically analyzed and tested on its
usefulness and validity.
The second part of this paper explains the basic elements surrounding the research of
bid-ask spread. Those are the financial market, market microstructure as well as
high-frequency data. In the following part the bid-ask spread itself, approaches,
researches and models focussing the spread will be discussed. The model of Roll
(1984) will be explained in detail. The last part will be the empirical analysis of the
model of Roll. It is analyzed with data from the NASDAQ.
Table of Contents
1 Introduction
2 Basic Facts
2.1 Financial Market
2.2 Market Microstructure
2.3 High-Frequency Data
3 Bid-Ask Spread
3.1 Definition
3.2 Approaches and Research
3.3 Roll-Model (1984)
4 Empirical Analysis of the Roll-Model
4.1 Data Analysis
4.2 Empirical Part
4.3 Conclusions
5 Final Remarks
Objectives and Research Themes
This paper examines the dynamics of the bid-ask spread within financial markets, focusing on the theoretical foundations and empirical validity of the Roll model (1984). The primary objective is to evaluate whether the Roll estimator serves as an effective measure for estimating transaction costs using high-frequency data from the NASDAQ.
- Theoretical analysis of market microstructure and price discovery mechanisms.
- Evaluation of high-frequency data characteristics and their impact on statistical models.
- Detailed exploration of the bid-ask spread components, including order processing, inventory, and adverse selection costs.
- Empirical testing of the Roll model to determine its applicability and limitations in contemporary markets.
Excerpt from the Book
3.3 Roll-Model (1984)
In 1984 Richard Roll published his article “A simple Implicit Measure of the Effective Bid-Ask Spread in an Efficient Market” in The Journal of Finance. He derives an implicit measure formally that infers the effective bid-ask spread directly from a time series of market prices. Like that only prices are needed. It is a deductive model, that means inferred from theory and empirically investigated.
The two basic assumptions of this model are an informational efficient market and that price changes are stationary. All transactions are made with a market maker and his spread is constant over time. There are no new information and like that the fundamental value of the security is fixed. Prices take on only two values, the bid and the ask. Successive transactions are equally likely to be a purchase or sale by the market maker. Like that observed price changes fluctuating between bid and ask prices. See illustration 1 in the appendix.
Summary of Chapters
1 Introduction: Provides an overview of the increasing complexity of financial markets and outlines the research objective concerning the empirical validity of the Roll model.
2 Basic Facts: Discusses the fundamental concepts of financial markets, market microstructure, and the unique challenges associated with analyzing high-frequency data.
3 Bid-Ask Spread: Defines the bid-ask spread, explores various research approaches, and introduces the theoretical framework of the Roll (1984) model.
4 Empirical Analysis of the Roll-Model: Presents the methodology for data analysis and conducts an empirical assessment of the Roll estimator using NASDAQ stock data.
5 Final Remarks: Summarizes the study's findings and acknowledges the limitations of the Roll model in explaining contemporary market phenomena.
Keywords
Financial Market, Market Microstructure, High-Frequency Data, Bid-Ask Spread, Roll Model, Price Discovery, Market Maker, Transaction Costs, Autocorrelation, Market Efficiency, NASDAQ, Equity Trading, Liquidity.
Frequently Asked Questions
What is the core focus of this research?
The paper focuses on the statistical properties of the bid-ask spread and how it influences price formation, specifically evaluating the Roll (1984) model's performance.
What are the primary thematic areas covered?
Key areas include market microstructure theory, the mechanics of bid-ask spreads, and the empirical application of time-series analysis on high-frequency financial data.
What is the main research question or goal?
The main goal is to test the empirical validity and usefulness of Richard Roll's estimator for calculating the effective bid-ask spread in modern financial markets.
Which scientific methods are utilized?
The study employs a deductive modeling approach, utilizing t-tests, Dickey-Fuller tests for stationarity, and empirical analysis of autocovariance using NASDAQ data.
What is addressed in the main body?
The main body covers the theoretical background of market microstructure, a detailed explanation of the Roll model, and an empirical chapter analyzing fourteen NASDAQ stocks.
Which keywords characterize this study?
Primary keywords include Bid-Ask Spread, Market Microstructure, High-Frequency Data, Roll Model, and Financial Market Efficiency.
Why is the Roll model considered "misspecified" in the later years of the study?
The study finds that the model frequently yields positive autocovariances, which invalidates the square-root calculation required for the Roll estimator, suggesting the model fails to account for current market complexities.
How do market makers influence the results of the Roll estimator?
Market makers' behavior, specifically their strategic management of inventory and quoted spreads, creates noise that often leads the Roll estimator to overestimate transaction costs in later periods.
- Quote paper
- Nadine Hirte (Author), 2003, High-frequency data analysis, Munich, GRIN Verlag, https://www.grin.com/document/26082
