Evaluating spread models with a basket security

Abstract

In this article we evaluate the most widely used spread decomposition models using Exchange Traded Funds (ETFs). These funds are an example of a basket security and allow the diversification of private information causing these securities to have lower adverse selection costs than individual securities. We use this feature as a criterion for evaluating spread decomposition models. Comparisons of adverse selection costs for ETF's and control securities obtained from spread decomposition models show that only the Glosten–Harris (1988) and the Madhavan–Richardson–Roomans (1997) models provide estimates of the spread that are consistent with the diversification of private information in a basket security. Our results are robust even after controlling for the stock exchange.

Keywords:

• spread decomposition
• market microstructure
• exchange traded-funds

JEL Classification::

• D8
• G1

Notes

¹ These results may reflect strategic behaviour that causes informed traders to trade smaller qualities to mask their identity. Empirical evidence for example by Barclay and Warner (1993) suggests that medium sized trades are more likely to be initiated by informed traders.

² Huang and Stoll (1997) model estimates the order processing costs by 1 – the adverse selection cost – the inventory cost.