Trading volume, bid-ask spread, and price volatility in futures markets

TLDR

Hausman's tests confirm that trading volume, bid‑ask spread, and price volatility are jointly determined in futures markets. The study investigates the relationships among trading volume, bid‑ask spread, and price volatility in four financial and metal futures. The authors estimated a three‑equation structural model of volume, spread, and volatility using generalized method of moments to obtain parameters and elasticities. The results show that higher trading volume is associated with higher price volatility but lower bid‑ask spread, while higher volatility increases spread and reduces lagged volume, and that GMM estimates differ markedly from OLS, implying that a transaction tax would lower volume, though less than previously estimated. © 2000 John Wiley & Sons, Inc., Jrl Fut Mark 20:943–970.

Abstract

In this study, we examined the relations between trading volume, bid–ask spread, and price volatility on four financial and metal futures. Hausman's (1978) tests of specification confirmed that trading volume, bid–ask spread, and price volatility are jointly determined. We estimated the parameters and elasticities of trading volume, bid–ask spread, and price volatility in a three-equation structural model, using the generalized method of moments (GMM) procedure. Results indicate that there was a positive relationship between trading volume and price volatility but an inverse relationship between trading volume and bid–ask spread after we controlled for other factors. Furthermore, results show that price volatility had a positive relationship with bid–ask spread and a negative relationship with lagged trading volume. In addition, we found that the ordinary least-squares parameter estimates of each equation model were often severely underestimated in comparison with those consistent estimates obtained from the GMM estimation. Results from this study have important policy implications. Our results indicate that a transaction tax, which is analogous to a greater bid–ask spread, will reduce trading volume, although the reduction is not as great as we previously estimated. © 2000 John Wiley & Sons, Inc. Jrl Fut Mark 20:943–970, 2000