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Equity Valuation and Portfolio Management by Harry M. Markowitz, Frank J. Fabozzi

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HIGH-FREQUENCY DATA ARE SUBJECT TO BID-ASK BOUNCE

In addition to trade price and volume data long available in low-frequency formats, high-frequency data comprise bid and ask quotes and the associated order sizes. Bid and ask data arrive asynchronously and introduce noise in the quote process.

The difference between the bid quote and the ask quote at any given time is known as the bid-ask spread. The bid-ask spread is the cost of instantaneously buying and selling the security. The higher the bid-ask spread, the higher a gain the security must produce in order to cover the spread along with other transaction costs. Most low-frequency price changes are large enough to make the bid-ask spread negligible in comparison. In tick data, on the other hand, incremental price changes can be comparable or smaller than the bid-ask spread.

Bid-ask spreads usually vary throughout the day. As an illustration, Exhibit 20.4 shows the average bid-ask spreads observed on SPY in April 2010. It shows the spreads during both the normal market hours and during so-called before and after-hours trading sessions. The before- and after-hours trading sessions are often accompanied by a thinner trading volume. As a result, the average spread increases significantly during trading hours when the market is quiet, as Exhibit 20.4 illustrates.

EXHIBIT 20.4 Average Bid-Ask Spreads on NYSE-Traded SPY for Different Hours of the Day during April 2010

Bid-ask spreads also increase during periods of market uncertainty ...

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