Relation between Bid-Ask Spread, Impact and Volatility in Double Auction Markets

Abstract

We show that the cost of market orders and the profit of infinitesimal market-making or -taking strategies can be expressed in terms of directly observable quantities, namely the spread and the lag-dependent impact function. Imposing that any market taking or liquidity providing strategies is at best marginally profitable, we obtain a linear relation between the bid-ask spread and the instantaneous impact of market orders, in good agreement with our empirical observations on electronic markets. We then use this relation to justify a strong, and hitherto unnoticed, empirical correlation between the spread and the volatility_per trade_, with R^2s exceeding 0.9. This correlation suggests both that the main determinant of the bid-ask spread is adverse selection, and that most of the volatilitycomes from trade impact. We argue that the role of the time-horizon appearing in the definition of costs is crucial and that long-range correlations in the order flow, overlooked in previous studies, must be carefully factored in. We find that the spread is significantly larger on the nyse, a liquid market with specialists, where monopoly rents appear to be present.