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An Empirical Examination of The Amortized Spread: John M.R. Chalmers !, Gregory B. Kadlec"
An Empirical Examination of The Amortized Spread: John M.R. Chalmers !, Gregory B. Kadlec"
Abstract
Theories of asset pricing suggest that the amortized cost of the spread is relevant to
investors required returns. The amortized spread measures the spreads cost over
investors holding periods and is approximately equal to the spread times share turnover.
We examine amortized spreads for Amex and NYSE stocks over the period 19831992.
We find that stocks with similar spreads can have vastly different share turnover, and
thus, a stocks amortized spread cannot be predicted reliably by its spread alone.
Consistent with theories of transaction costs, we find stronger evidence that amortized
spreads are priced than we find for unamortized spreads. ( 1998 Elsevier Science S.A.
All rights reserved.
JEL classification: G10
Keywords: Transaction costs; Bidask spread; Share turnover
* Corresponding author. Tel.: #1 540 231 4316; fax: #1 540 231 3155; e-mail: kadlec@vt.edu.
1 Prior versions of this paper were entitled, Bidask spreads, holding periods, and realized
transaction costs. We are grateful for many helpful comments from Yakov Amihud, Jennifer
Conrad, Larry Dann, Diane Del Guercio, Dave Denis, Diane Denis, Craig Dunbar, Ed Dyl, Roger
Edelen, Rob Hansen, Mark Huson, Raman Kumar, Chris Lamoureux, John McConnell, Wayne
Mikkelson, Megan Partch, Henri Servaes, Vijay Singal, Mike Weisbach, Marc Zenner, and an
anonymous referee. In addition, we appreciate the comments from seminar participants at the 1997
American Finance Association meetings, the University of Arizona, Kansas State University, the
University of North Carolina, the 1996 Pacific Northwest Finance Conference, Virginia Polytechnic
Institute, and the University of Wisconsin. This work has been partially supported by a summer
research grant from the Pamplin College of Business.
0304-405X/98/$19.00 ( 1998 Elsevier Science S.A. All rights reserved
PII S 0 3 0 4 - 4 0 5 X ( 9 7 ) 0 0 0 0 7 - 5
160
1. Introduction
While the role of transaction costs in asset pricing remains the subject of
debate, few would argue with the basic premise that transaction costs affect an
individuals required return. For example, an individuals required return on
a stock will equal his required return in the absence of a bidask spread, plus the
percentage bidask spread amortized over the individuals expected holding
period. The theoretical debate over the importance of transaction costs in asset
pricing arises primarily from differing assumptions regarding investors holding
periods. Amihud and Mendelson (1986) assume that individuals trade for
liquidity purposes with an average holding period of 1.6 years. Under this
assumption, spreads are amortized over relatively short holding periods, and
thus, the amortized cost of transacting is large. As a result, Amihud and
Mendelsons model predicts that bidask spreads have a significant effect on
asset returns. Alternatively, Constantinides (1986) assumes that individuals
trade only to rebalance their portfolios. Under this assumption, spreads are
amortized over relatively long holding periods, and thus, the amortized cost of
transacting is small. Consequently, Constantinides model predicts that bidask
spreads have only a second-order effect on asset returns.2
Empirical studies of the relation between stock returns and bidask spreads
have not resolved this debate. Amihud and Mendelson (1986) find a significant
positive relation between stock returns and bidask spreads, while Chen and
Kan (1989) find an insignificant relation and Eleswarapu and Reinganum (1993)
find that the relation between stock returns and bidask spreads is significant
only in the month of January. However, these studies focus solely on the
magnitude of the spread without consideration of the length of the holding
period over which spreads are amortized. For example, Amihud and Mendelson
(1986), Chen and Kan (1989), and Eleswarapu and Reinganum (1993) all use
closing bidask spreads as a proxy for the expected cost of the spread. If stocks
with similar spreads trade with different frequency, the magnitude of the spread
is not a sufficient proxy for the amortized cost of the spread.
We examine amortized spreads, which explicitly capture both the magnitude
of the spread and the length of investors holding periods. We define the
amortized spread as the product of the effective spread and the number of shares
traded summed over all trades for each day and expressed as an annualized
fraction of equity value. Intuitively, the amortized spread measures the annualized cost of the spread to investors and is approximately equal to the
effective spread times share turnover. We compute amortized spreads for the
2 For other theories of optimal investment policy and asset pricing under transaction costs see, i.e.,
Brennan (1975), Goldsmith (1976), Levy (1978), Milne and Smith (1980), Mayshar (1981), Aiyagari
and Gertler (1991), and Vayanos and Vila (1995).
161
universe of U.S. domiciled common stocks listed on either the Amex or NYSE at
any time during the period 19831992.
We find that, while the average round-trip effective spread of Amex/NYSE
stocks is 2.2% of equity value, the average annual amortized spread is only 0.5%
of equity value. More importantly, because stocks with similar spreads can have
vastly different share turnover, a stocks amortized spread cannot be predicted
reliably by its spread alone. For example, transportation stocks have lower
effective spreads than stocks of firms in consumer goods, financial, capital goods,
and basic goods. However, due to their higher share turnover, transportation
stocks have higher amortized spreads than stocks in any of these industries.
Our analysis of the determinants of the amortized spread reveals that a stocks
amortized spread is strongly related to its return volatility, a variable that is
positively related to both spreads and share turnover. For example, utility
stocks, which have relatively low return volatility, have both low spreads and
low share turnover, and thus, low amortized spreads. By contrast, technology
stocks, which have relatively high return volatility, have both high spreads and
high share turnover, and thus, high amortized spreads.
We argue that, in the context of asset pricing, the amortized spread is a more
relevant measure of transaction costs than the spread. Consistent with this view,
we find stronger evidence that amortized spreads are priced than we find for
spreads. However, we interpret these asset pricing results with caution due to the
limited sample period (19831992) over which the tests are conducted. Given the
current interest in market value of equity and book-to-market as factors in
security returns, we also examine the relation between amortized spreads and
these two variables. Although amortized spreads are negatively related to
market value of equity and positively related to book-to-market, multivariate
asset pricing tests show that the explanatory power of the amortized spread is
not subsumed by market value of equity or market-to-book.
The remainder of the paper is organized as follows. Section 2 defines our
measure of the amortized spread and describes the data that are used to
calculate it. Section 3 reports cross-sectional and time-series descriptive statistics of amortized spreads. In Section 4, we examine determinants of the amortized spread. In Section 5, we estimate the relation between stock returns and
two alternative measures of spread-related transaction costs, amortized spreads
and unamortized spreads. Section 6 summarizes our findings and discusses their
implications. The Appendix provides details concerning the methodology used
in the asset pricing tests.
2. Amortized spreads
In this section we formally define our measure of the amortized spread and
describe the data that we use to calculate the amortized spread.
162
(1)
AS+
)
,
P
SharesOut
(2)
which is also the effective spread divided by the average holding period (1/turnover). Thus, a stock which has an effective spread of 4% and annual turnover of
50% would have an annual amortized spread of 2%. If expected gross returns
include reimbursement for expected transaction costs, cross-sectional differences
in amortized spreads provide a benchmark for assessing the potential impact of
bidask spread-related transaction costs on security returns.
The amortized spread in Eq. (1) has several important features as a measure of
transaction costs. First, it is calculated with effective spreads rather than quoted
spreads. Theoretical models of the bidask spread, such as Amihud and Mendelson (1980), Ho and Stoll (1981), and Glosten and Milgrom (1985) typically
analyze the specialists quoted spread. However, it is the effective spread at
which investors conduct trades, and thus is the more relevant measure for
163
computing transaction costs.3 Blume and Goldstein (1992), Lee (1993), and
Petersen and Fialkowski (1994) find that the effective spread is approximately
5070% of the specialists quoted spread. More importantly, Petersen and
Fialkowski (1994) report that the cross-sectional correlation between the effective spread and the quoted spread is less than 0.31.
Second, Eq. (1) incorporates investors holding periods since it is calculated
from actual trades. The length of investors expected holding periods determines
the spreads impact on required returns. For example, Barclay and Smith (1988)
show that an individuals required return on a stock can be expressed as the
required rate of return in the absence of a spread plus the percentage bidask
spread amortized over the investors expected holding period. Thus, the shorter
the expected holding period, the greater the impact of the bidask spread on an
individuals required return.
Third, our measure of the amortized spread implicitly incorporates the depth
of the spread quote. Lee et al. (1993) argue that no measure of the spread is truly
meaningful without information concerning its depth. Eq. (1) incorporates the
constraint imposed by the depth of quote because it measures the cost of
completed trades.
There are some potential limitations of our measure. First, the amortized
spread reflects only transaction costs associated with the bidask spread. Other
costs of transacting may also be priced, such as brokerage fees, commissions,
and price movement. Second, while the impact of bidask spreads on required
returns is determined by expected holding periods, our measure of the amortized
spread reflects realized holding periods. This limitation is important if a stocks
amortized spread is driven largely by unanticipated shocks to turnover. To
address this concern, we provide evidence which suggests that a stocks amortized spread is relatively stable over time. Finally, our measure of the amortized
spread reflects the average holding period of all investors. If a large portion of
a firms stock is held by an individual with an unusually long holding period, our
measure may understate the amortized spread for the marginal investor. Notwithstanding these important qualifications, we believe that, in the context of
asset pricing, our measure of the amortized spread is a more relevant measure of
transaction costs than the simple magnitude of the spread.
3 The effective spread measure as defined by Blume and Goldstein (1992) and Lee (1993) and used
here to compute amortized spreads has at least two limitations as a measure of the cost of the spread.
First, to the extent that the specialists quotes lie asymmetrically about the true price the effective
spread measure, which compares transaction prices to the midpoint of the bidask quote, may either
understate or overstate the true spread. Though, there is no reason to believe that this source of error
results in biased estimates. Second, if a market order is matched directly with another market order
the effective spread measure will overstate the actual cost of the spread (which on average is zero).
However, Hasbrouck (1988) suggests that such occurrences are rare.
164
0.29%
0.43%
0.67
0.44%
1.46%
0.33
0.21%
0.67%
0.46
Low
Decile
0.44%
1.22%
0.41
0.34%
0.53%
0.63
0.28%
0.74%
0.53
0.51%
1.09%
0.51
0.42%
0.66%
0.63
0.34%
0.84%
0.60
0.58%
0.98%
0.61
0.50%
0.80%
0.64
0.44%
1.00%
0.68
0.59%
0.91%
0.71
0.56%
0.98%
0.60
0.56%
1.20%
0.73
0.60%
0.77%
0.81
0.71%
1.43%
0.54
0.78%
1.62%
0.78
0.63%
0.65%
1.02
0.88%
2.26%
0.47
0.99%
1.92%
0.84
0.82%
0.59%
1.48
1.17%
4.16%
0.37
1.76%
2.81%
1.03
High
0.51%
1.11%
0.60
0.51%
1.11%
0.60
0.51%
1.11%
0.60
Avg.
Panels A, B and C present cross-sectional and time-series averages of the amortized spread and its components, the effective spread and share turnover for
all U.S. based stocks traded on the Amex or NYSE at any time during the period from 19831992. A stocks amortized spread is the product of the effective
spread and the number of shares traded summed over all trades and expressed as an annual percent of equity value. The effective spread is the difference
between the transaction price and the midpoint of the prevailing bidask quote. Share turnover is equal to the annual share volume divided by the number
of shares outstanding. In panel A, stocks are assigned to deciles based upon their average monthly amortized spread rank. In panel B, stocks are assigned
based upon their average monthly effective spread rank. In panel C, stocks are assigned based upon their average monthly share turnover rank. In each
case, decile 1 refers to the lowest values of the ranking variable and decile 10 are stocks that exhibit the largest values for the ranking variable.
Table 1
Average amortized spreads, effective spreads, and share turnover
166
167
To more formally assess the relation between amortized spreads and effective
spreads, we estimate the Pearson and Spearman correlation between amortized
spreads and effective spreads. The cross-sectional correlations between average
amortized spreads and average effective spreads are 0.54 (Pearson) and 0.59
(Spearman). The imperfect correlation between amortized spreads and effective
spreads is due to the fact that not all stocks with the same spread trade with the
same frequency. In Amihud and Mendelsons (1986) framework, there is a perfect correlation between spreads and amortized spreads because all stocks with
the same spread trade with the same frequency. This feature of Amihud and
Mendelsons (1986) model is not supported by the data in Table 1. If all stocks
with the same spread traded with the same frequency, deciles formed by spread
(panel B) would be the exact inverse of deciles formed by turnover (panel C).
This is not the case. For example, the average spread of the highest spread decile
(panel B) is 4.16%, while the average spread of the lowest share turnover decile
(panel C) is 1.84%.
Finally, it is interesting to note that stocks with high amortized spreads have
both high effective spreads and high share turnover, while stocks with low
amortized spreads have both low effective spreads and low share turnover.
From panel A, stocks in the highest amortized spread decile have average
effective spreads of 2.8% and average share turnover of 103%, while stocks in
the lowest amortized spread decile have average effective spreads of 0.5% and
average share turnover of 23%. The positive association between spread and
share turnover in panel A is in contrast to Amihud and Mendelsons (1986)
clientele effect, whereby stocks with higher spreads are held for longer periods
than stocks with lower spreads.
Fig. 1 provides a more detailed view of the surface of amortized spreads in the
dimensions of the effective spread and share turnover. Panel A displays the
average amortized spread for stocks falling into the various spread ranks (from
panel B of Table 1) and share turnover ranks (from panel C of Table 1). The
number of stocks in each cell is presented in panel B of Fig. 1. As previously
noted, there is little variation in amortized spreads across most stocks. Note that
the only stocks with markedly different amortized spreads are found in the high
spread/high turnover region of Fig. 1A. Fig. 1B reveals that few stocks fall into
this category. Furthermore, stocks with similar spreads can have vastly different
amortized spreads because of differences in share turnover. For example, in
spread rank ten, the average effective spread is 4.16%, yet these stocks average
amortized spreads range from 0.5% to 3.5%. Likewise, due to differences in
turnover, stocks with vastly different spreads can have similar amortized
spreads. For example, in spread rank ten, turnover rank one, we find 92 stocks
with average amortized spreads of 0.50%, and in spread rank one, turnover rank
ten, we find 57 stocks with average amortized spreads of 0.37%. Table 1 and
Fig. 1 provide evidence that stocks with similar spreads can exhibit vastly
different amortized spreads and stocks with vastly different spreads can exhibit
168
Fig. 1. The surface of amortized spreads. A stocks amortized spread is the product of the effective
spread and the number of shares traded summed over all trades and expressed as an annualized
percent of equity value. The effective spread is the difference between the transaction price and the
prevailing bidask midpoint. Share turnover is equal to the annualized volume of shares traded
divided by the number of shares outstanding. In panels A and B, stocks are assigned to effective
spread/share turnover cells based upon their average monthly effective spread rank and their
average monthly share turnover rank. The sample includes U.S. based stocks traded on either the
Amex or NYSE from 19831992. In each case, decile 1 refers to the lowest values of the ranking
variable and decile 10 includes stocks that exhibit the largest values for the ranking variable.
169
similar amortized spreads. This is why one cannot infer the amortized cost of
transacting on the basis of the spread alone.
3.2. Time-series properties
The ranking procedure we use to form the deciles in Table 1 is designed to
capture a stocks long run amortized spread. However, this ranking method will
obscure variation in the amortized spreads of individual stocks over time.
A natural question concerns the stability of a stocks amortized spread over
time. To address this question, we provide several pieces of evidence.
Fig. 2 plots the time-series of monthly amortized spreads for stocks assigned
to deciles on the basis of their amortized spread rank in 1983. For clarity, we
focus on amortized spread deciles one and ten. We compare the amortized
spread of deciles one and ten to the average amortized spread of all stocks in
each sample month. The relative stability of a stocks amortized spread is
immediately apparent. In particular, the amortized spreads for deciles one and
ten never revert to the average amortized spread over the ensuing nine year
period.4 This simple experiment shows that, even over a protracted period of
time, a stocks amortized spread is relatively stable.
To more formally assess the stability of a stocks amortized spread over time,
we estimate the correlation between a stocks average amortized spread in year
t and its average amortized spread in year t!1. Over the 10 year period from
1983 to 1992, the average of the nine correlation coefficients is 0.56. The average
correlation between a stocks amortized spread rank in year t and its amortized
spread rank in year t!1 is 0.81. To determine whether the stability of the
amortized spread is due to the stability of the effective spread or the stability of
a stocks share turnover, we repeat the above analysis for the effective spread
and share turnover. The average of the nine correlation coefficients between
a stocks average effective spread in year t and its average effective spread in year
t!1 is 0.75. The average correlation between a stocks effective spread rank in
year t and its effective spread rank in year t!1 is 0.93. The average of the nine
correlation coefficients between a stocks average share turnover in year t and its
average share turnover in year t!1 is 0.65. The average correlation between
a stocks share turnover rank in year t and its share turnover rank in year t!1
is 0.79.
Finally, we examine the correlation of a stocks amortized spread, effective
spread, and share turnover between two five year sub-periods (19831987 and
19881992). The correlation coefficient for a stocks average amortized spread,
4 In 1983, decile 1 includes a maximum of 214 firms and finishes the 10 year period with 139 firms.
Likewise, decile 10 includes a maximum of 219 firms in 1983 and finishes the 10 year period with 85
firms. The monthly average amortized spread is calculated from an average of 1988 stocks.
Fig. 2. Stability of the amortized spread. Monthly average amortized spreads of U.S. domiciled stocks traded on NYSE or Amex are plotted from January
1983 through December 1992. A stocks amortized spread is the product of the effective spread and the number of shares traded summed over all trades
and expressed as an annualized percent of equity value. Amortized spread deciles one and ten include the stocks with the lowest and highest, respectively,
average monthly amortized spread rank in 1983. The monthly mean amortized spread is plotted for the surviving firms from deciles one and ten over the
entire 120 month period, with the first twelve months being the ranking period. The average amortized spread for all sample firms in each month is
presented for reference. The average number of firms used in the calculation of the average amortized spread is 1976. Decile 1 includes a maximum of 214
firms in 1983 and finishes the 10 year period with 139 firms. Decile 10 includes a maximum of 219 firms in 1983 and finishes the 10 year period with 85 firms.
170
J.M.R. Chalmers, G.B. Kadlec/Journal of Financial Economics 48 (1998) 159188
171
effective spread, and share turnover between these two periods are 0.52, 0.55 and
0.51, respectively. The correlation for a stocks amortized spread rank, effective
spread rank, and share turnover rank between these two periods are 0.78, 0.86,
and 0.74, respectively. These results suggest that there are persistent factors
which influence a stocks amortized spread.
5 For theories of the bidask spread see Demsetz (1968), Treynor (1971), Amihud and Mendelson
(1980), Ho and Stoll (1981), Glosten and Milgrom (1985). For empirical evidence see Bensten and
Haggerman (1974), Stoll (1989), Glosten and Harris (1988), and George et al. (1991).
6 For theories of trade see Constantinides and Ingersoll (1984), Kyle (1985), Karpoff (1986),
Constantinides (1986) and Harris and Raviv (1993). For empirical evidence see Atkins and Dyl
(1997a), Bessembinder et al. (1996).
172
Table 2
Determinants of spreads, turnover, and amortized spreads
Table 2 reports coefficient estimates for cross-sectional regressions of effective spreads, share
turnover, and the amortized spread on share price, return volatility, and spreads or share turnover
where applicable. Panel A reports coefficient estimates from regressions of the effective spread on
stock price, stock return variance and share turnover. Panel B reports coefficient estimates from
regressions of share turnover on stock return variance and the effective spread. Panel C reports
coefficient estimates from regressions of the amortized spread on stock price, and stock return
variance. For each cross-sectional observation, we use time-series means of stock prices, share
turnover, effective spreads, and amortized spreads, and calculate return variance from monthly
returns over each stocks available sample period. We use logarithmic transformations of the
variables. Standard errors are presented in parentheses. Each of the coefficient estimates has an
associated p-value less than 0.01.
Panel A: Dependent variable effective spread
Intercept
Turnover
Price
Return variance
Adj-R2
!2.06
(0.02)
!0.14
(0.01)
!0.70
(0.01)
0.24
(0.01)
0.91
3366
Effective spread
Return variance
Adj-R2
!1.58
(0.07)
!0.71
(0.02)
0.60
(0.02)
0.28
3366
Price
Return variance
Adj-R2
!2.59
(0.06)
!0.24
(0.02)
0.56
(0.02)
0.48
3366
We begin with the cross-sectional relation between effective spreads and stock
price, stock return variance, and share turnover. The coefficients reported in
panel A are consistent with prior studies of the determinants of the spread. In
particular, the coefficient of stock price is negative (!0.70) and significant
(p-value(0.0001), the coefficient of stock return variance is positive (0.24) and
significant (p-value(0.0001) and the coefficient of share turnover is negative
(!0.14) and significant (p-value(0.0001). Though not reported in Table 2,
coefficient estimates from regressions of quoted bidask spreads on share price,
volatility, and share turnover are nearly identical to those reported in panel A.
173
7 Given the fact that the spread and turnover are functions of one another, the regressions of
panels A and B have an endogeneity problem. We do not attempt to resolve this issue. We report the
results of regression that are similar to prior studies.
38%
25%
17%
9%
5%
2%
3%
0%
1%
0%
0.17%
0.38%
0.45
5.96%
Decile mean:
Amortized spreads
Effective spread
Turnover
Standard deviation of return
Low
volatility
0.20%
0.45%
0.53
7.89%
21%
21%
18%
16%
12%
6%
4%
1%
0%
0%
Volatility decile
Low
2
3
4
5
6
7
8
9
High
0.26%
0.51%
0.62
9.03%
10%
17%
18%
20%
18%
9%
6%
2%
1%
1%
0.33%
0.61%
0.65
10.08%
10%
11%
12%
13%
17%
14%
12%
6%
3%
1%
0.38%
0.76%
0.65
11.17%
7%
10%
10%
15%
13%
19%
12%
9%
5%
2%
0.45%
0.85%
0.71
12.39%
5%
6%
9%
8%
11%
17%
16%
18%
7%
3%
0.60%
1.08%
0.78
13.88%
2%
4%
7%
6%
8%
11%
19%
14%
18%
11%
0.78%
1.62%
0.73
15.80%
3%
1%
4%
6%
6%
11%
11%
16%
21%
19%
1.04%
2.25%
0.76
18.78%
1%
1%
2%
3%
4%
6%
10%
20%
22%
30%
1.40%
3.50%
0.68
27.84%
1%
2%
2%
3%
6%
6%
7%
15%
24%
34%
High
volatility
For the stocks in each volatility decile, we report the percentages that are found in each of the amortized spread deciles defined in Table 1. In addition,
mean amortized spreads, effective spreads, share turnover and standard deviation of monthly returns are reported for each volatility decile. A stocks
amortized spread is the product of the effective spread and the number of shares traded summed over all trades and expressed as an annual percent of
equity value.
Table 3
Return volatility and the amortized spread
174
J.M.R. Chalmers, G.B. Kadlec/Journal of Financial Economics 48 (1998) 159188
175
Table 4
Industry profiles of the amortized spread
For each industry, we report the percentage of stocks within that industry that fall into each of the
amortized spread deciles defined in Table 1. The industry classification scheme is based upon Roll
(1992) with the exception of technology, which Roll (1992) does not define. In addition, mean
amortized spreads, effective spreads, share turnover and standard deviation of monthly returns are
reported for each industrial classification. A stocks amortized spread is the product of the effective
spread and the number of shares traded summed over all trades and expressed as an annual percent
of equity value. The number of firms within each industrial classification is reported directly below
the classification label.
Amortized
spread decile
Low
2
3
4
5
6
7
8
9
High
Industry mean:
Amortized
spreads
Effective spread
Turnover
Standard deviation of return
Energy
(32)
3%
4%
4%
7%
7%
10%
10%
14%
21%
20%
6%
2%
11%
6%
6%
7%
15%
19%
13%
15%
8%
10%
9%
9%
10%
10%
11%
11%
10%
11%
16%
10%
10%
13%
10%
9%
8%
9%
9%
7%
5%
7%
12%
9%
12%
10%
14%
11%
9%
10%
28%
16%
13%
16%
13%
3%
9%
0%
0%
3%
0.73%
0.67%
0.59%
0.55%
0.26%
1.28%
0.86
0.16
1.02%
0.91
0.13
1.19%
0.68
0.14
1.15%
0.62
0.13
0.50%
0.53
0.09
10%
10%
10%
10%
11%
13%
10%
10%
9%
8%
21%
20%
17%
13%
7%
6%
5%
4%
4%
5%
176
177
2%
3%
4%
5%
8%
10%
9%
15%
18%
26%
1.00%
3.41%
0.39
9
Decile mean:
Amortized spreads
Effective spread
Turnover
Market value
(millions)
0.77%
2.07%
0.48
22
4%
7%
8%
9%
11%
7%
11%
10%
17%
16%
Small firms 2
Size decile
Low
2
3
4
5
6
7
8
9
High
Amortized
spread decile
0.76%
1.72%
0.55
42
5%
8%
6%
10%
6%
7%
16%
15%
13%
14%
0.62%
1.20%
0.60
73
10%
7%
10%
7%
11%
7%
9%
16%
12%
10%
0.57%
0.90%
0.71
124
11%
8%
9%
8%
6%
12%
8%
13%
10%
15%
0.49%
0.73%
0.72
199
10%
11%
8%
9%
10%
15%
11%
10%
11%
7%
0.49%
0.61%
0.84
337
10%
11%
9%
11%
9%
12%
13%
9%
9%
7%
0.35%
0.56%
0.76
610
15%
15%
10%
10%
13%
9%
11%
6%
8%
3%
11%
12%
16%
13%
14%
15%
9%
6%
3%
2%
0.30%
0.39%
0.80
1203
0.20%
0.29%
0.71
5319
21%
19%
20%
17%
12%
6%
3%
1%
0%
0%
Large firms
For the stocks in each size decile, we report the percentages of stocks in the size decile that are found in each of the amortized spread deciles defined in
Table 1. In addition, mean amortized spreads, effective spreads, share turnover and market value (in millions) are reported for each size decile. A stocks
amortized spread is the product of the effective spread and the number of shares traded summed over all trades and expressed as an annual percent of
equity value.
Table 5
Market value of equity and the amortized spread
178
J.M.R. Chalmers, G.B. Kadlec/Journal of Financial Economics 48 (1998) 159188
12%
11%
14%
14%
5%
7%
10%
6%
7%
12%
0.48%
0.86%
0.71
0.22
Decile mean:
Amortized spread
Effective spread
Turnover
Book-to-market
0.42%
0.79%
0.66
0.39
12%
12%
10%
8%
12%
11%
11%
8%
10%
7%
Low B/M 2
Book-to-market decile
Low
2
3
4
5
6
7
8
9
High
0.51%
0.81%
0.67
0.50
12%
9%
10%
10%
14%
8%
7%
10%
9%
10%
0.46%
0.88%
0.66
0.61
13%
10%
10%
8%
10%
10%
8%
8%
12%
10%
0.44%
0.92%
0.62
0.70
10%
14%
11%
15%
9%
10%
8%
8%
8%
7%
0.48%
1.02%
0.59
0.82
10%
8%
16%
10%
8%
11%
9%
6%
11%
11%
0.46%
1.03%
0.54
0.90
13%
11%
9%
8%
10%
12%
10%
11%
8%
8%
0.54%
1.25%
0.55
1.06
10%
8%
6%
11%
13%
10%
11%
13%
14%
6%
0.54%
1.14%
0.60
1.29
5%
9%
8%
9%
12%
10%
10%
13%
10%
14%
0.63%
1.63%
0.55
2.18
4%
9%
4%
7%
7%
10%
16%
16%
11%
16%
High B/M
For the stocks in each book-to-market decile, we report the percentage of those stocks that are found in each of the amortized spread deciles defined in
Table 1. In addition, mean amortized spreads, effective spreads, share turnover and book-to-market are reported for each book-to-market decile.
Observations for which B/M is negative are not included in the sample used to construct this table. A stocks amortized spread is the product of the
effective spread and the number of shares traded summed over all trades and expressed as an annual percent of equity value.
Table 6
Book-to-market and the amortized spread
180
the previous years book value of equity to market value of equity if B/M is
positive, and zero if B/M is negative, p
is the standard deviation of monthly
j,t~1
returns estimated with three to five years of data, as available, prior to the test
year, and C
measures expected transaction costs with either the expected
j,t~1
effective spread or the expected amortized spread of security j. Returns are
measured from July 1 to June 30 of the following year. We use annual returns
rather than monthly returns in an attempt to sidestep the statistical problems
that arise from the seasonality and measurement biases found in stock returns
during the month of January. For example, Bhardwaj and Brooks (1992) and
Huson (1995) find that bidask bounce causes the relations between stock
returns and market value of equity and stock returns and bidask spread to be
overstated during the month of January. Details concerning the estimation of
the independent variables in the above cross-sectional regressions are discussed
in the appendix.
Table 7 reports coefficient estimates from cross-sectional regressions of stock
returns on beta, market value of equity, book-to-market, standard deviation of
return and our two alternative measures of transaction costs. Before discussing
the results we raise two caveats. First, given data availability constraints (ISSM
data is available only from 1983 to 1992), we are able to conduct our asset
pricing tests using only nine years of data. Prior empirical studies which
examine the relation between stock returns and bidask spread related transaction costs utilize 20 or more years of data. However, these studies use year-end
closing bidask quotes as a proxy for costs incurred from the bidask spread. To
our knowledge, this study is the first to test the relation between stock returns
and the effective spread as opposed to the quoted spread.
Second, from Table 1 we know that the cross-sectional variation in amortized
spreads for Amex/NYSE stocks is relatively small. The variation in our estimates of expected amortized spreads is even smaller. For example, while the
interdecile range of amortized spreads is 1.7% (Table 1), the interdecile range of
our estimates of expected amortized spreads is 1%. Thus, it is possible that the
amortized cost of transacting is important, yet the variation in amortized
spreads for our sample stocks is not great enough to allow detection. One way to
address this issue would be to conduct our asset pricing tests using securities
with greater variation in amortized spreads, say NASDAQ stocks. Unfortunately, reported volume for NASDAQ stocks is highly inflated due to interdealer
trading and there is no systematic way to correct for differences in the overstatement across stocks (see Atkins and Dyl, 1997b).
We begin with the cross-sectional relation between stock returns and amortized spreads. From panel A of Table 7, we find weak support for a crosssectional relation between stock returns and amortized spreads. In particular,
the time-series average coefficient of the amortized spread is positive with
two-tailed p-values ranging from 0.02 to 0.18 for the alternative regression
specifications. Furthermore, the coefficient of the amortized spread is insensitive
181
Table 7
The relation between stock returns and amortized spreads
Asset pricing tests are conducted in the spirit of Fama and MacBeth (1973). Using OLS, we estimate
the cross-sectional relation between each stocks annual return in excess of the one-year treasury
yield and b, the log of the market value of equity, the book-to-market ratio in year t!1, the
standard deviation of monthly returns, and, in panel A, the amortized spread, and, in panel B, the
effective spread. Annual returns are measured from July 1 of each year through June 30 of the
following year. Betas are estimated using a two-stage procedure similar to Kothari et al. (1995).
Market value of equity is estimated immediately prior to each test year. Standard deviation of return
is the standard deviation of monthly returns estimated with three to five years of data, as available,
prior to the test year. A stocks spread is the average effective spread over the preceding twelve
months. Amortized spreads are estimated as the product of the effective spread estimate and the
average level of share turnover for each firm over the stocks entire sample period. Panels A and
B contain time-series averages of the nine cross-sectional regression coefficients. Standard errors are
presented in parentheses. p-values for a two-tailed t-test are provided in square brackets.
Panel A: Returns and amortized spreads
r "c #c b #c ME
#c (B/M)
#c p
#c Amortized Spread
#e
j,t
0,t
1,t j
2,t
j,t~1 3,t
j,t~1 4,t j,t~1 5,t
j,t~1 j,t
Dependent variable: Return in excess of 1 year t-bill yield for firm j
Intercept
Mean coefficient
(std err)
[p-value]
Mean coefficient
(std err)
[p-value]
Mean coefficient
(std err)
[p-value]
Mean coefficient
(std err)
[p-value]
b
j
0.13
(0.04)
[0.01]
!0.03
(0.12)
[0.78]
!0.07
(0.10)
[0.54]
0.20
(0.13)
[0.16]
!0.08
(0.02)
[0.00]
!0.07
(0.01)
[0.00]
!0.07
(0.01)
[0.00]
!0.02
(0.02)
[0.42]
ME
j,t~1
0.01
(0.01)
[0.19]
0.01
(0.01)
[0.11]
0.00
(0.01)
[0.99]
(B/M)
p
j,t~1 j,t~1
0.01
(0.02)
[0.45]
0.00
(0.02)
[0.79]
!1.35
(0.48)
[0.02]
Amortized
Spread
i,t~1
4.12
(2.82)
[0.18]
4.62
(2.58)
[0.11]
4.54
(2.58)
[0.12]
7.89
(2.87)
[0.02]
Mean coefficient
(std err)
[p-value]
0.12
(0.04)
[0.01]
b
j
!0.07
(0.02)
[0.01]
ME
j,t~1
(B/M)
p
j,t~1 j,t~1
Effective
Spread
i,t~1
0.43
(2.12)
[0.84]
182
Table 7 (Continued)
Panel B: Returns and effective spreads
r "c #c b #c ME
#c (B/M)
#c p
#c Effective Spread
#e
j,t
0,t
1,t j
2,t
j,t~1
3,t
j,t~1
4,t j,t~1
5,t
j,t~1
j,t
Dependent variable: Return in excess of 1 year t-bill yield for firm j
Mean coefficient
(std err)
[p-value]
Mean coefficient
(std err)
[p-value]
Mean coefficient
(std err)
[p-value]
Intercept
b
j
ME
j,t~1
!0.12
(0.14)
[0.43]
!0.15
(0.14)
[0.33]
0.05
(0.15)
[0.73]
!0.06
(0.02)
[0.01]
!0.06
(0.02)
[0.00]
!0.00
(0.02)
[0.81]
0.02
(0.01)
[0.11]
0.02
(0.01)
[0.08]
0.01
(0.01)
[0.32]
(B/M)
p
j,t~1 j,t~1
0.01
(0.02)
[0.42]
0.00
(0.02)
[0.77]
!1.37
(0.36)
[0.00]
Effective
Spread
i,t~1
2.04
(2.77)
[0.48]
1.91
(2.76)
[0.51]
3.64
(2.64)
[0.20]
183
those of Eleswarapu and Reinganum (1993), who use the Fama and MacBeth
(1973) methodology over a similar time period.
The strong contemporaneous association between the amortized spread and
return volatility observed in Table 3 raises the question of whether return volatility is a viable proxy for the amortized spread. Prior studies find a weak and
inconsistent cross-sectional relation between stock returns and historical standard
deviation of returns (i.e., Fama and MacBeth, 1973). Nevertheless, it is interesting
to examine whether the inclusion of standard deviation of returns in the regression
of Eq. (3) has any impact on the coefficient of the amortized spread. If, in fact,
standard deviation of returns is a viable proxy for the amortized spread, one
would expect to observe a positive coefficient for the standard deviation of returns
and, because of their high correlation, a less significant coefficient for the amortized spread. We estimate Eq. (3) with the addition of each stocks standard
deviation of monthly returns estimated over three to five years preceding each test
year, as available. Surprisingly, the coefficient for standard deviation of returns is
negative, !1.35, and significant (t-statistic !2.81, p-value(0.05), while the
coefficient for the amortized spread is now larger (7.9) and significant (t-statistic
2.75, p-value(0.05). The negative coefficient estimate for return volatility appears to be related to the negative risk premium over this period. In particular, the
coefficient estimate for beta is insignificant with the inclusion of standard deviation of return in the regression. Coefficient estimates for market value of equity
and book-to-market in this regression are insignificantly different from zero.
Thus, it appears that, if there is a relation between stock returns and standard
deviation of returns, it is distinct from that of the amortized spread. However, as
with all of our asset pricing results, we interpret these with caution due to the
limited and unique period over which the tests are conducted.
Finally, because data on quoted spreads are more readily available than data
on effective spreads, we repeat the regressions from panel A of Table 7 using
quoted spreads to calculate amortized spreads. The coefficient estimates for the
amortized quoted spread are similar to those for the amortized effective spread
reported in panel A. For example, the time-series average coefficient of the
amortized quoted spread is positive (3.1; t-statistic 1.37) when accompanied by
beta, market value of equity, and book-to-market. The coefficient estimates for
the unamortized quoted spread are similar to those for the unamortized effective
spread reported in panel B. For example, the time-series average coefficient of
the quoted spread is 0.94 (t-statistic"0.36) when accompanied by beta, market
value of equity, and book-to-market.9 These results do, however, suggest that
the effective spread conveys more information than the quoted spread.
9 As a practical matter, it is important to note that neither the amortized effective spread nor the
amortized quoted spread are priced when a single end-of-period observation is used to estimate the
spread. For example, using periods from July 1 to June 30, if for each stock the amortizd spread is
calculated from a single spread observation on June 30th and multiplied by the average turnover,
this measure of the amortized spread is not significant in Fama and MacBeth-type regressions.
184
185
186
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