Bid and Ask - Explained
What is Bid and Ask?
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Table of ContentsWhat is Bid and Ask?How Does Bid and Ask Work?Who Benefits from the Bid-Ask Spread?Academic Research on "Bid and Ask"
What is Bid and Ask?
The bid and ask is a term used in the stock market to describe the lowest amount sellers are willing to sell their stock and the highest amount buyers are willing to pay for the stock. The bid and ask is otherwise called bid and offer, this is the best prices buyers and sellers are willing to transact stock in the marketplace. While the bid price refers to the highest price a buyer offers to buy a security, the asking price is the minimum amount a seller wants to sell the security. Without the bid and ask price, there can be no smooth transactions in the stock market.
How Does Bid and Ask Work?
Oftentimes, there is a spread between the bid and ask in the marketplace. This is the difference between the amount quoted by the buyer and seller for the purchase and sale of stock. In some cases, the spread might be small while in other cases, there is a huge spread between the prices quoted by the buyer and seller. How much difference is recorded between the asking price and bid price of a security is an indicator of how liquid the asset or security is.
Who Benefits from the Bid-Ask Spread?
Generally, the bid and ask price affects the market maker the most, this is the person that quotes the price. How much of a spread exists between the bid and ask price determined the amount of profit that the market maker would earn. There are diverse factors responsible for the bid-ask spreads, the type of security, current market price and other market factors that determine the degree of a bid-ask spread. Also, market conditions affect the benefit that a market maker would derive from a bid and ask spread. For instance, when there is a crisis in the market, investors might be unwilling to buy securities at prices above the market threshold.
Academic Research on "Bid and Ask"
- Asset pricing and the bid-ask spread, Amihud, Y., & Mendelson, H. (1986). Asset pricing and the bid-ask spread.Journal of financial Economics,17(2), 223-249. This paper studies the effect of the bid-ask spread on asset pricing. We analyze a model in which investors with different expected holding periods trade assets with different relative spreads. The resulting testable hypothesis is that market-observed expexted return is an increasing and concave function of the spread. We test this hypothesis, and the empirical results are consistent with the predictions of the model.
- Bid, ask and transaction prices in a specialist market with heterogeneously informed traders, Glosten, L. R., & Milgrom, P. R. (1985). Bid, ask and transaction prices in a specialist market with heterogeneously informed traders.Journal of financial economics,14(1), 71-100. The presence of traders with superior information leads to a positive bid-ask spread even when the specialist is risk-neutral and makes zero expected profits. The resulting transaction prices convey information, and the expectation of the average spread squared times volume is bounded by a number that is independent of insider activity. The serial correlation of transaction price differences is a function of the proportion of the spread due to adverse selection. A bid-ask spread implies a divergence between observed returns and realizable returns. Observed returns are approximately realizable returns plus what the uninformed anticipate losing to the insiders.
- The dynamics of discretebid and askquotes, Hasbrouck, J. (1999). The dynamics of discrete bid and ask quotes.The Journal of finance,54(6), 2109-2142. This paper presents an empirical microstructure model of bid and ask quotes that features discreteness, random costs of market making, and ARCH volatility effects. Applied to intraday quotes at 15minute intervals for Alcoa (a randomly chosen Dow stock), the results show that quote exposure costs contain stochastic components that are persistent and large relative to the deterministic intraday U components. Analysis of the filtered estimates of the system suggest that bid and ask costs contain common components, and that these costs reflect risk as proxied by ARCH variance forecasts.
- An analysis of prices, bid/ask spreads, andbid and askdepths surrounding Ivan Boesky's illegal trading in Carnation's stock, Chakravarty, S., & McConnell, J. J. (1997). An analysis of prices, bid/ask spreads, and bid and ask depths surrounding Ivan Boesky's illegal trading in Carnation's stock.Financial Management, 18-34. During the three-month period prior to the acquisition of Carnation by Nestl in 1984, Ivan Boesky purchased 1.7 million shares of Carnation's stock on the basis of illegally obtained inside information. Detailed records of Boesky's trades permit us to examine the relation between his trading and Carnation's stock price, bid/ask spread, and bid and ask depth. We find a positive and significant relation between Boesky's trades and stock price changes, but bid/ask spreads appear to be unaffected, and depths appear to be unaffected or improved by his trades.
- Trade size and components of the bid-ask spread, Lin, J. C., Sanger, G. C., & Booth, G. G. (1995). Trade size and components of the bid-ask spread.The Review of Financial Studies,8(4), 1153-1183. The relation between theorized components of the bid-ask spread and trade size for a sample of NYSE firms is examined. We find that the adverse selection component increases uniformly with trade size. Conversely, order processing costs decrease with increases in trade size for all but the largest trades. We find that order persistence decreases with trade size. The adverse selection component is highest at the beginning of the day and lowest at the end of the day for all but the largest trades. Trades of NYSE firms executed on regional exchanges or NASDAQ contain a large order processing cost component but no significant adverse information effect.