A Study on the Indian Market Microstructure
Student Name: Rakhi S
Liquidity has increasingly become an important tool for the investors to
select their trading venue and securities. Bid-Ask spread is widely used
as a measure of liquidity in the dealer market, where it is directly observable.
A smaller Bid-Ask spread is an indication of a security being more liquid.
In an oder-driven market like NSE, India, the Bid-Ask spread is not
directly observable. Though it can be computed using Roll's formula
from high frequency intra-day transaction data in an order driven market,
the utility of this metric as a proxy for liquidity measure in an order
driven market has not been extensively studied in the literature. In this
study an attempt has been made in this direction. High frequency transaction
data are collected for July-August 2004 for 50 Nifty stocks and 27 randomly
selected NSE listed but outside S& P 500 stocks (and thus expected to be
much less liquid). Next daily Bid-Ask spread, measured using Roll's formula,
rupee volume, volatlity, median share price and number of trades are observed
for these stocks. The Bid-Ask spread is then regressed on the remaining four
variables for each stock using the daily data and the regression coefficients
are recorded. Next these regression coefficients are studied individually
for the two groups and compared between themselves using one and two sample
t-tests and Wilcoxon test. It is found that for the highly liquid 50 Nifty
stocks, the Bid-Ask spread decreases as the rupee volume increases, or
volatility decreases, or median share price decreases, or number of trades
decreases. While the first three results intuitively makes sense the last
one is counter-intuitive giving rise to the question of suitability of either
Roll's formula or the notion of Bid-Ask spread being a "good" measure
of liquidity in an order-driven market. For the illiquid stocks however
though the directions of influence of the four variables on the Bid-Ask
spread are found to be similar to that of the highly liquid stocks, the
results of the rupee volume and the number of trades are found to be
statistically insignificant. That is for the illiquid stocks it is found
that the Bid-Ask spread decreases as the volatility increases, or median
share price increases, but it has no significant association with rupee
volume or number of trades. No significant difference is found to exist
between the liquid and illiquid stocks for all the four regression
coefficients. Thus it is concluded on the whole that irrespective of
a stock being liquid or illiquid, caution should be taken in using Roll's
formula for the Bid-Ask spread as a proxy for liquidity for an order
driven market, necessiating further research for an appropriate measure
of liquidity of securities being traded in an order-driven market.