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Evaluating spread models with a basket security

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  • Patricia Chelley-Steeley
  • Keebong Park

Abstract

In this article we evaluate the most widely used spread decomposition models using Exchange Traded Funds (ETFs). These funds are an example of a basket security and allow the diversification of private information causing these securities to have lower adverse selection costs than individual securities. We use this feature as a criterion for evaluating spread decomposition models. Comparisons of adverse selection costs for ETF's and control securities obtained from spread decomposition models show that only the Glosten--Harris (1988) and the Madhavan--Richardson--Roomans (1997) models provide estimates of the spread that are consistent with the diversification of private information in a basket security. Our results are robust even after controlling for the stock exchange.

Suggested Citation

  • Patricia Chelley-Steeley & Keebong Park, 2012. "Evaluating spread models with a basket security," Applied Financial Economics, Taylor & Francis Journals, vol. 22(4), pages 259-283, February.
    • Handle: RePEc:taf:apfiec:v:22:y:2012:i:4:p:259-283
    DOI: 10.1080/09603107.2011.589803
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    1. Madhavan, Ananth, 2000. "Market microstructure: A survey," Journal of Financial Markets, Elsevier, vol. 3(3), pages 205-258, August.
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