A Theoretical Model and Empirical Analysis of Components of Spread in
Over The Counter Exchange of India
Student Name: Jyothi G. Rao
High frequency transaction data from
January 1995 to December 1995 of the Over The Counter Exchange of India (OTCEI)
were studied in this thesis for analyzing its bid-ask spread. The spread was
first analyzed using existing methodologies available in the literature with
further statistical enhancements. Then a new theoretical model was developed
for decomposing the bid-ask spread into its constituent cost components of
order processing, inventory holding and adverse information, arising in any
dealer market (not necessarily only in OTCEI), by extending the classical
Stoll's financial model for this problem. This new model was then applied to
the OTCEI data and the cost components were extracted and compared with the
ones obtained from the existing methods. The OTCEI data did not exactly conform
to the proposed theoretical model and thus some empirical fine tunings were
necessary to accomplish this goal. This led to the development of a data driven
empirical model, which was built around the skeleton of the proposed new
theoretical financial model. The relative importance of the cost components in
OTCEI were found to be similar using both new theoretical and empirical models,
though their magnitude differed significantly. The existing models however
painted a somewhat different picture. In particular, the order processing cost
was found to be much lower using the new methodologies, which was attributed to
the other two components under the existing methodologies. The reasons for
failure of OTCEI and subsequent Dave committee recommendations however, could
be put in better perspective, based on the findings of the newly developed
methodologies than the existing ones.