The components of the bid†ask spread: Evidence from the corn futures market

This article examines whether USDA announcements and commodity index fund rolling activity have an impact on liquidity costs, measured by the bid†ask spread. Using Huang and Stoll's (1997) model of liquidity costs, we estimate whether changes to liquidity costs are driven by its adverse selection, inventory, or order processing components. Commodity index fund roll activity reduces the asymmetric information cost component of liquidity cost due to an increased proportion of noninformation†based trading, but the inventory cost component increases as (mostly long only) commodity index funds sell their nearby positions and buy the first deferred contract—raising liquidity providers’ risk of building a position. The sum of these two effects is that liquidity costs remain low during index fund roll periods, averaging one “tick†(0.25 cents). On USDA report release days, we find that informed traders raise the asymmetric information component of liquidity costs in the first hour after release, but the inventory cost component is reduced due to the increase in volume. Similar to index fund roll activity, liquidity costs on USDA report release days remain low, averaging one “tick†. Our findings that liquidity costs are minimally changed during USDA report releases and commodity index fund roll periods is consistent with other recent research on liquidity costs, but we show that what drives liquidity costs differs substantially depending on the circumstances surrounding daily trading.