refers to this difference. In the section that follows, we
examinewhythisdifferenceexists,howlargeitisasacost,
and the determinants of its magnitude.
Why Is There a Bid-Ask Spread?
Inmostmarkets,thereisadealerormarketmakerwhosets
thebid-askspread,andtherearethreetypesofcoststhatthe
dealerfacesthatthespreadisdesignedtocover.Thefirstis
the cost of holding inventory, the second is the cost of
processingorders,andthefinalcostisthecostoftradingwith
moreinformedinvestors.Thespreadhastobelargeenough
to cover these costs and yield a reasonable profit to the
market maker on his or her investment in the profession.
The Inventory Rationale
Consider market makersor specialists on thefloor of the
exchange whohave to quotebid prices and askprices, at
whichtheyareobligatedtoexecutebuyandsellordersfrom
investors. These investors, themselves, could be trading
becauseofinformationtheyhavereceived(informedtraders),
forliquidity(liquiditytraders),orbasedontheirbeliefthatan
assetisundervaluedorovervalued(valuetraders).Insucha
market,ifthemarketmakerssetthebidpricetoohigh,they
willaccumulateaninventoryofthestock.Ifmarketmakers
settheaskprice toolow,theywillfindthemselves witha
largeshortpositioninthestock.Ineithercase,thereisacost
to themarket makers thatthey willattempt to recover by
increasing the spread between the bid and ask prices.
Marketmakersalsooperatewithinventoryconstraints,some
of which are externally imposed (by the exchanges or