What are the three components of the bid-ask spread?

Question

AcadiFi · Accepted Answer

The bid-ask spread decomposes into: (1) Order processing cost — fixed costs of maintaining a market (technology, staff, exchange fees). (2) Inventory holding cost — compensation to market-makers for risk of holding unbalanced positions. (3) Adverse selection cost — compensation for losses to informed traders who exploit private information.

Formal decomposition (Stoll 1989, Huang-Stoll 1997): Spread = 2 * (alpha + beta + gamma), where alpha ~ adverse selection, beta ~ inventory, gamma ~ processing.

Example estimates for large-cap equity (e.g., Gladstone Industries): total spread 4 bps, of which ~1.5 bps processing, ~1.0 bps inventory, ~1.5 bps adverse selection. For small-cap (Hollisworth Components): total spread 45 bps, ~5 bps processing, ~10 bps inventory, ~30 bps adverse selection. Informed trading dominates in small caps.

```mermaid
flowchart TD
  A[Bid-Ask Spread] --> B[Order Processing]
  A --> C[Inventory Risk]
  A --> D[Adverse Selection]
  B --> E[Fixed costs]
  C --> F[Position risk]
  D --> G[Information asymmetry]
```

Practical implication: decomposition guides execution strategy. If adverse selection dominates (as in small caps or around news events), patient limit-order strategies suffer; better to use aggressive execution. If processing/inventory dominates (large caps, calm markets), passive liquidity provision is cheaper. For risk managers, rising adverse-selection components signal information-driven stress — often a leading indicator of market dislocation.

What are the three components of the bid-ask spread?

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