regulatory agencies) and some of which are internally
imposed (due to limited capital and risk). As the market
makers’ inventory positions deviate from their optimal
positions,theybearacostandwilltrytoadjustthebidand
ask prices to get back to their desired positions. If the
inventoryistoohigh,thebidpricehastobelowered;ifthe
inventory is too low, the ask price has to be raised.
The Processing Cost Argument
Since market makers incur a processing cost with the
paperworkandfeesassociatedwithorders,thebid-askspread
hastocover,attheminimum,thesecosts.Whilethesecosts
arelikelytobeverysmallpershareforlargeordersofstocks
tradedontheexchanges,theybecomelargerforsmallorders
of stocks that might be traded only through a dealership
market.Furthermore,sincealargeproportionofthiscostis
fixed,thesecostsasapercentageofthepricewillgenerally
be higher for low-priced stocks than for high-priced stocks.
Technology clearly has reduced the processing cost
associated with trades as computerized systems take over
fromtraditionalrecordkeepers.Thesecostreductionsshould
begreatestforstockswherethebulkofthetradesaresmall
trades—small stocks held by individuals rather than
institutional investors. Not surprisingly, spreads have
decreased most for these stocks.
The Adverse Selection Problem
The adverse selection problem arises from the different
motives investors have for trading on an asset—liquidity,
information,andviewsonvaluation.Sinceinvestorsdonot