announcetheirreasonsfortradingatthetimeofthetrades,
themarketmakeralwaysrunstheriskoftradingagainstmore
informed investors. Since the expected profits from such
trading are negative, the market maker has to charge an
averagespreadthatislargeenoughtocompensateforsuch
losses.Thistheorywouldsuggestthatspreadswillincrease
withtheproportionofinformedtradersinanassetmarket,the
differential information possessed, on average, by these
traders, and uncertainty about future information on the asset.
Magnitude of the Bid-Ask Spread
The New York Stock Exchange reported
2 thattheaveragebid-askspreadacrossallNYSEstocksin
1996 was $0.23, which seems trivial especially when one
considersthefactthattheaveragepriceofaNYSEstockis
between$40and $50.Thisaverage,however, obscuresthe
largedifferencesinthecostasapercentageofthepriceacross
stocks,basedoncapitalization,stockpricelevel,andtrading
volume. A study by Thomas Loeb in 1983, for instance,
reportedthespreadfor smallordersasa percentageofthe
stock price for companies as a function of their market
capitalization.
3 These results are summarized inFigure 14.1.
FIGURE 14.1Prices and Spreads by Market Cap
Source:Loeb (1983).