The Sensitivity of Effective Spread Estimates to Trade-Quote Matching Algorithms

We find that effective spread estimates are sensitive to trade–quote matching algorithms. In particular, Lee and Ready's 5‐second algorithm can overestimate effective spreads for active stocks. The sensitivities can be particularly important for stocks in which a significant amount of trading occurs electronically. We develop a criterion to determine the optimal algorithm and demonstrate that it provides consistent and appropriate estimates. We demonstrate that a simple algorithm of matching trades with contemporaneous quotes provides good estimates of effective spreads during our sample period. We also document that using trade execution times, instead of report times, to match trades with quotes can reduce effective spread estimates by 0.24 cents, or about 3%, for active stocks.

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