Impact and Volatility in Order-Driven Markets

Abstract

We argue that on electronic markets, competition between liquidity providers should reduce the spread until the execution cost using market orders matches that of limit orders. This implies a linear relation between the bid-ask spread and the average impact of market orders, in good agreement with our empirical observations. We then use this relation to justify a strong, and hitherto unnoticed, empirical correlation between the spread and the volatility per trade, with Rs exceeding 0.9. This suggests that the main determinant of the bid-ask spread is adverse selection, provided one considers the volatility per trade as a measure of the amount of ‘information’ included in prices at each transaction. Our methodology, which extends the work of Madhavan, Richardson & Roomans, allows us to compare meaningfully the spreads in different markets. We find that the spread is significantly larger on the nyse, a liquid market with specialists.

16 Figures and Tables

Cite this paper

@inproceedings{Wyart2006ImpactAV, title={Impact and Volatility in Order-Driven Markets}, author={Matthieu Wyart and Jean-Philippe Bouchaud and Julien Kockelkoren and Marc Potters and Michele Vettorazzo}, year={2006} }