Spread decomposition with common spread components

This paper aims to incorporate a market wide buying and selling pressure cost component into a spread decomposition model as spread cost component.

The paper extends a commonly used trade indicator spread decomposition model to include a component common to all stocks of a specialist firm and a market wide component common to all stocks.

Strong evidence is found that specialists consider this common factor cost component when they set bid and ask quotes. Some specialist firms also take the next logical step and specifically manage their firm wide stock inventories. The common factor is in percentage terms largest for securities with the highest trade frequencies.

The relative importance of the common factor spread component decreases as the pricing grid becomes finer, but remains highly significant under the decimal trading regime.

This is the first study to document not‐security‐specific spread cost components that are common to all stocks for which a specialist firm makes markets and to all stocks in the market. Using the model it is shown that market wide uncertainty translates into spreads of individual securities.