The Effects of Inventory Costs and Adverse

Information on Relative Bid-Ask Spreads:

The Case of Teiefonos de Mexico Shares
Kam C. Chan and Gim S. Seow

This study analyzes the relative bid-ask spreadfor the two classes of common shares offered by Teiefonos De Mexico
that are listed on the NYSE and the NASDAQ. The effects of security price, security risk, trading volume, number of
market makers, and extent of informed trading on the relative bid-ask spreads for the two securities are examined
before and after the listing of the NYSE issue on May 14,1991. For the NASDAQ issue, we compare the pre- and
post-period relative spreads and factors influencing them. The difference in relative spreads between the NYSE and
NASDAQ issues is examined together with the suggestedfactors. Our empirical evidence appears consistent with the
factors suggested by the inventory cost and adverse information theories as important determinants of the relative
bid-ask spread.

• A security's bid-ask spread, which is defined as the
relative bid-ask spread, is calculated as the difference
between the bid and ask prices divided by the average of the
bid and ask prices. The relative spread represents an important
component of the transactions costs confronting a trader who
seeks immediacy in the execution of buy or sell orders. In
executing orders for traders, the dealer in a security offers to
buy at the bid and sell at the ask. Thus, the relative spread is
a measure of the cost of the dealer's services and is an
indication ofa security's marketability. Research in relative
bid-ask spreads offers two theories for explaining the relative
spread of a security. The inventory cost theory focuses on the
additional fundamental risk borne by risk-averse dealers who
hold more than the desired inventory level, thus forcing a
deviation from their optimal portfolio position. The dealers
then establish a relative spread that will maximize profits
while maintaining an optimal inventory level (see Amihud
and Mendelson, 1980, Garman, 1976, Ho and StoU, 1981,
and Stoll, 1978a). These models predict that relative bid-ask
spreads increase with the security risk and decreases with
security price, liquidity, and the number of market makers.
Empirical work by Benston and Hagerman (1974), Demsetz
Kam C, Chan is Assistant Professor of Accounting, and Gim S. Seow is
Assistant Professor of Accounting, Both are at the University of
Connecticut, Storrs, CT 06269.
We thank James E, Shapiro (NYSE) and Leith Wheeler (NASDAQ) for
providing actual daily closing bid and ask price data and Scott Sumner for
research assistance. Our paper also benefited from the helpful comments
and suggestions of two anonymous referees.
(1968), and Tinic and West (1972) provide support for the
inventory theory. The other theory, based on information
asymmetry, focuses on the adverse selection risk created by
traders with superior information. Here the dealer's objective
is to set the relative spread such that the profit from
uninformed or liquidity-motivated traders exceeds the loss
caused by informed traders. According to the information
asymmetry theory, the relative spread should increase with
order size and the number of sophisticated traders (see
Copeland and Galai, 1983, Easley and O'Hara, 1987, and
Glosten and Milgrom, 1985),
This study investigates the factors affecting the relative
bid-ask spreads of two foreign common stocks issued by the
same company that are listed in two major U.S. exchanges.
The foreign company examined in this study is Teiefonos De
Mexico, which is interesting for at least three reasons. One,
it is the only company we know of that offers two classes of
common shares that trade primarily or exclusively on two
separate U.S. exchanges: the Series L shares (TMX) are
listed on the New York Stock Exchange, while the Series A
shares (TFONY,A) are traded on the NASDAQ, The NYSE
issue represents twenty shares of the Mexican Series L, while
the NASDAQ issue represents only one share of the Mexican
Series A. The TMX issue is also listed on the Midwest and
Philadelphia Stock Exchanges, The side by side listings offer
a unique opportunity to examine the relative spread theories
for the same underlying asset in two markets simultaneously.
Two, Teiefonos De Mexico is one of the major foreign
corporations listed in the U.S. The two stocks participate in

68
CHAN & SEOW—INVENTORY COSTS AND ADVERSE INFORMATION EFFECTS ON RELATIVE BID-ASK SPREADS 69

the growing globalization trend while also providing U.S, beginning January 1, 2001, the Series L shares may be
investors an opportunity to diversify intemationally. Finally, exchanged into an AA share provided that the AA and A
underwriters and their clients on the supply side as well as shares together may never represent less than 51% of the
investors on the demand side are interested in the effect of capital stock, and AA shares are subject to limitations on
security liquidity on firm value. The liquidity of a security in non-Mexican ownership. The above set of conditions
a particular market is an important consideration for a presents an interesting background for re-examining the
company deciding where to list its new securities. Research factors influencing the relative bid-ask spreads in two major
by Amihud and Mendelson (1986) suggests that increasing stock exchanges and for comparing the relative bid-ask
liquidity may increase the value of the firm. They document spread of the NASDAQ issue before and after the listing of
a positive relationship between market-observed average the NYSE issue,
returns and the relative bid-ask spread, implying that a lower
relative spread results in a lower expected return. This lower
expected retum translates into a higher security value. In
II. Predictions and Tests
their example, a financial asset yielding 2% each month with The inventory cost theory predicts that the relative spread
a high initial relative spread of 3,2% will experience a 50% of a security is positively related to its risk and negatively
appreciation in value if its relative spread is reduced to a low related to its price, trading volume, and number of market
of 0.486%, This clearly demonstrates the strong managerial makers. On the other hand, the information asymmetry
incentives to improve the liquidity of publicly traded theory predicts that the larger the number of informed traders
securities. or the order size, the larger the relative spread. The effects of
the various factors on the relative bid-ask spread can be
A brief description of Telefonos De Mexico shares is
expressed as:
presented in the next section, followed by a discussion of
the theories' predictions, data collection, and hypotheses -I- - -
development. Empirical results and their inferences are Relative Spread = f (Risk, Price, Volume,
presented in Section IU, In the final section, a few concluding
+ +
comments are provided, Market makers. Informed traders. Order size)
The positive relation between relative spread and risk is
I. Telefonos de Mexico Shares suggested by Branch and Freed (1977), Demsetz (1968) and
The American Depository Receipts (ADR) for Series A Branch and Freed (1977) hypothesize that the relative spread
common shares of Telefonos De Mexico, S.A, (TFONY,A) should increase as the stock price decreases. Studies by Stoll
have been traded in the NASDAQ since December 14, 1972. (1978a and 1978b) present support for the inverse relation
Outstanding Series A shares numbered 559 million at between relative spread and volume. Increasing the level of
year-end 1993, On May 14, 1991, a new ADR for its Series competition, as evidenced by increasing the number of
L common (TMX) was introduced in the New York Stock market makers, is hypothesized to lead to a smaller relative
Exchange. Outstanding Series L shares numbered 7,881 spread (see Stoll, 1978a). The effect of order size on the
million at the end of 1993. A third class, the Series AA share, relative spread is reported in Copeland and Galai (1983) and
is only traded in the Mexican Stock Exchange and may only Easley and O'Hara (1987), These predictions from prior
be held by Mexican nationals. As of December 31, 1993, research are tabulated in Exhibit 1.
2,163 million Series AA shares were outstanding, with 51% For the NASDAQ issue, the daily bid and ask quotes
owned by institutions, controlling 79% of the voting rights. prior to June 15, 1992, are extracted from the CRSP Daily
All three classes. Series AA, A, and L shares, have equal File, and bid and ask data subsequent to that date are obtained
pre-emptive, liquidation, and dividend rights. While the from the CRSP Supplemental NASDAQ File. To compare
Series A A and A shares have equal voting rights on all the relative spread of the NASDAQ issue in the pre- and
matters, the Series L shares only have voting rights on major post-period, data are collected for 415 trading days
matters affecting the firm. Another interesting feature of immediately before May 14, 1991, and also for 414 trading
these shares are their conversion terms. Both the Series AA days immediately after May 14, 1991, Closing stock price,
and A shares may be exchanged at the option of the holder stock retums, and trading volume are obtained from the
for one L share, provided that the AA shares may never CRSP tapes. The daily relative bid-ask spread is measured
represent less than 20% of the outstanding capital stock or as the difference between the bid and ask prices divided by
less than 51 % of the combined AA and A shares. However, the average of the bid and ask prices. The daily trading
70 FINANCIAL PRACTICE & EDUCATION— FALLTWINTER 1995

Exhibit 1. Predictions of Relative Spread Theories"

Factors Inventory Theory Information Theory

Increasing Security Risk Larger spread
Increasing Security Price Smaller spread
Increasing Volume Smaller spread
More Market Makers Smaller spread
More Informed Traders Larger spread
Larger Order Size Larger spread

^Relative spread is defined as the difference between the bid and ask prices divided by the average of the bid and ask prices.

Exhibit 2. Descriptive Statistics of Relative Bid-Ask Spreads

NASDAQ Issue (TFONY)

Pre Post
Mean Relative Bid-Ask Spread 0.0246 0.0158
Standard Deviation 0.0113 0.0053
Median 0.0194 0.0139
Minimum 0.0000 0.0000
Maximum 0.0869 0.0399
Number of Observations" 415 414

"For the NASDAQ issue during the post-period, the number of trading days is 414 days because of one missing data point on the
CRSP tapes.

volume is calculated as the number of shares traded
multiplied by the daily stock price. Finally, monthly data on
the number of market makers for the NASDAQ issue are
obtained from the Historical Research Department of
NASDAQ, Inc. The series covers a period consisting of
twenty months before and twenty months after the NYSE
listing date. To compare the relative spreads between the
NYSE and NASDAQ issues, we obtained actual daily
closing bid and ask price quotes for twenty trading days
during January 1993. Bid and ask quote data are provided by
the research departments at NYSE and NASDAQ, for which
the authors are very grateful.
Statistical analysis is divided into two parts. The first part
involves a comparison between the pre- and post-period for
the NASDAQ issue. The purpose is to investigate the effects
of various factors associated with inventory costs and
adverse information on the relative bid-ask spread. The
second part involves a comparison between the NYSE and
NASDAQ issues during January 1993, after the former has
been listed. For both parts, factors such as security price,
security risk, mean trading volume, and the number of
market makers are contrasted using the F- and t-tests.
III. ROSUltS
Descriptive statistics ofdaily relative bid-ask spreads and
daily trading volume in dollars for both Telefonos De
Mexico issues are presented in Fxhibit 2. For the NASDAQ
issue, the mean relative bid-ask spread for the 415 trading
days before May t4, 1991, was 2.46% compared to a mean
relative spread of almost 1.58% for the 414 trading days
immediately after May 14, 1991. This decrease in mean
relative spread is statistically significant (t = 14.371; p-value
= 0.0001) and may be the result of competitive pressures
from the NYSE issue.
To examine the effect of the information asymmetry
theory for the NASDAQ issue during the pre-and post-period,
this study employs the number of institutional traders and
their aggregate share holdings as a proxy for informed traders
and order size. For instance. Potter (1992) finds institutional
ownership to be positively related to transaction size and
CHAN & SEOW—INVENTORY COSTS AND ADVERSE INFORMATION EFFECTS ON RELATIVE BID-ASK SPREADS 71

Exhibit 3. Institutional Ownership in Telefonos De Mexico Shares

NASDAQ NYSE
Month/Year No. of Firms Shares in 000s No. of Firms S h a r e s in 000s
1/91 25 87,227
2/91 46 104,657
3/91 70 137,068
4/91 86 174,150
5/91 101 202,195
6/91 114 268,509
7/91 119 269,089
8/91 100 178,873 92 85,308
9/91 94 78,733 178 117,006
10/91 97 63,153 208 129,342
11/91 97 63,153 208 129,342
12/91 87 38,364 248 135,108
12/92 58 18,318 472 144,372
12/93 36 19,479 637 124,918

Source: Standard and Poor's Stock Guide,

block size. Institutional traders affiliated with pension and
mutual funds are usually associated with larger orders
because of their need to adjust larger portfolios regularly.
Exhibit 3 shows these two measures over the period 1991 -93,
monthly for 1991 and year-end for 1992 and 1993,
For the NASDAQ issue, the number of institutional
investors (number of shares held) gradually increased from
25 (87 million shares) in January 1991 to 119 (269 million
shares) in July 1991. After July 1991, the institutional
ownership level dropped off precipitously. With the listing
of the NYSE issue, institutions interested in Telefonos De
Mexico securities switched from the NASDAQ issue to the
NYSE issue. Given that the price ofthe NYSE issue is twenty
times that of the NASDAQ issue, trading in the Big Board
may be more convenient and saves on commissions. The
observed decrease in the NASDAQ relative spread after May
14, 1991, accompanied by a decline in institutional trading,
is therefore consistent with the information asymmetry
theory.
Next, we examine the other four factors associated with
the inventory cost theory. Empirical results reported in
Exhibit 4 show that the decrease in relative spread
corresponds with an increase in the average stock price,
and a decline in security risk, as measured by the variance
of daily returns. The increase in the number of market
makers from the pre- to the post-period is statistically
significant (t = -3.738). This implies that an increase in the
level of competition is associated with a reduction in the
relative bid-ask spread. All three effects are consistent with
the inventory cost theory. The dollar trading volume for the
NASDAQ issue decreased significantly (t = 8,816) after the
listing of the NYSE issue from a daily average of $12,54
million in the pre-period to only $4.73 million in the
post-period. This is not consistent with one of the factors
predicted by the inventory cost theory. Overall, the results in
Exhibit 4 suggest that inventory cost factors such as the
security risk, share price, and the number of market makers
affect the relative bid-ask spread ofthe NASDAQ issue.
In Exhibit 5, the relative bid-ask spreads and inventory
cost factors for both the NYSE and NASDAQ issues are
presented. The average relative spread for the NYSE issue
was 0.29%, and the average relative spread for the
NASDAQ issue was 1.18% in January 1993, The difference
in relative spread between the NYSE and NASDAQ issues
is statistically significant (t = -23,7), The larger relative
spread for the NASDAQ issue corresponds with a lower
stock price and a smaller trading volume relative to the
NYSE issue. The directions indicated by these factors are
consistent with the inventory cost theory. The level of
informed trading, as proxied by the average number of
institutional investors, is not in the predicted direction. An
explanation for this result is that the inventory costs and
adverse information theories are not mutually exclusive. We
interpret our results in Exhibit 5 as demonstrating a tradeoff
72 FINANCIAL PRACTICE & EDUCATION—FALL/WINTER 1995

Exhibit 4. Pre- and Post-Period Test Results for the NASDAQ Issue

Variables Pre Post Test Statistics

Relative Bid-Ask Spread 0.0246 0.0158 t = 14.371
(P = 0.0001)
Security Risk" 0.000625 0.000479 F 1.300
(P = 0.01)
Average Security Price 1.547 2.280 t = -19.702
(P = 0.0001)
Mean Trading Volume in $ millions $12,539 $4,725 t = 8.816
(P = 0.0001)
Average Number of Market Makers'' 41.5 44.3 t = -3.738
(P = 0.0006)
Number of Observations'^ 415 414 414

"As measured by the variance ofdaily retums.

''Month-end data oti the nutnber of tnarket tnakers for the NASDAQ issue are obtained frotn NASDAQ's Historical Research
Department. The pre- and post-period means are estimated from adjacent twenty-month periods: September 1989 through April 1991
and May 1991 through December 1992, respectively.
'^The number of observations do not apply to the number of market makers, which are explained in note b. The number of trading days
is less than 415 days in some cases because of missing data on the CRSP tapes.

Exhibit 5. Comparison Test Results for NYSE versus NASDAQ Issues

Variables NYSE NASDAQ Test Statistics

Relative Bid-Ask Spread'' 0.0029 0.0118 t = -23.70
(P = 0.0001)
Security Risk"'' 0.000358 0.000382 F 1.07
(P = 0.8957)
Average Security Price" 55.875 2.800 t = 18.10
(P 0.0001)
Mean Trading Volume in $ millions" $116,009 33.726 t 5.748
(P = 0.0001)
Average Number of Institutional Investors'^ 465 65 t = 12.10
(P = 0.0001)
Number of Observations'* 20 20 20

^These measures are computed using data from January 1993.

As measured by the variance ofdaily retums during January 1993.
'^Estimated from monthly data starting in July 1992 and ending in June 1993.
For both issues, we estimate the relative bid-ask spreads using the actual daily closing bid and ask quotes for the twenty trading days
in January 1993. Data are provided by the New York Stock Exchange and the NASDAQ.

among factors associated with the two theories. One
interpretatioti of our results is that the benefits of lower
inventory costs (or more liquidity) is offset by the disadvantage
of more itiformed trading in the NYSE. In the NASDAQ,
however, less informed trading is offset by higher inventory
costs. Together with evidence presented in Exhibits 3 and 4,
our results suggest that factors associated with the inventory
cost theory and adverse information play dominant roles in
determining the relative bid-ask spread.
In late 1994, the drastic decline in the value of the
Mexican peso resulted in the dramatic fall in prices of both
the NYSE and NASDAQ issues. As an update, we obtained
CHAN & SEOW—INVENTORY COSTS AND ADVERSE INFORMATION EFFECTS ON RELATIVE BID-ASK SPREADS
the closing hid and ask prices for both issues on Friday,
February 24, 1995, from Fidelity Investments, The NYSE
issue closed at $28,375 with a bid price of $28.25 and an
ask price of $28.50. The relative bid-ask spread is 0.881%.
The NASDAQ issue closed at $ 1 -7/16 with a bid of $ 1 -13/32
and an ask of $1-7/16. Its relative spread is 2.198%. Both
relative spreads have increased in light of the uncertainties
surrounding the volatility of the Mexican exchange rate and
the political environment in Mexico,
IV. Conclusions
This study uses a major foreign company, Telefonos
De Mexico, to examine five factors influencing the relative
bid-ask spread. The firm under study has two classes of
References
Amihud, Yakov and Haim Mendelson, 1980, "Dealership Market: Market
Making with Inventory," Journal of Financial Economics 8:1
(March), 31-53.
Amihud, Yakov and Haim Mendelson, 1986, "Asset Pricing and the
Bid-Asked Spread," Journal of Financiai Economics 17:2
(December), 223-249.
Benston, George J. and Robert L. Hagerman, 1974, "Determinants of
Bid-Asked Spreads in the Over-the-Counter Market," Journal of
Financial Economics 1:4 (December), 353-364.
Branch, Ben and Walter Freed, 1977, "Bid-Asked Spreads on the AMEX
and the Big Board," Journai of Finance 32:1 (March), 159-163.
Copeland, Thomas E. and Dan Galai, 1983, "Information Effects on the
Bid-Ask Spread," Journai of Finance 38:5 (December), 1457-1469.
Demsetz, Harold, 1968, "The Cost of Transacting," Quarterly Journal of
Economics 82:1 (February), 33-53.
Easley, David and Maureen O'Hara, 1987, "Price, Trade Size, and
Information in Securities Markets," Journal of Financial Economics
19:1 (September), 69-90.
Garman, Mark B., 1976, "Market Microstructure," Journal of Financial
Economics 3:3 (June), 257-275.
73
common stocks, one recent listing on the NYSE and an older
issue that has been traded on the NASDAQ since 1972. This
circumstance enables us to compare the relative bid-ask
spread ofthe NASDAQ issue before and after the new NYSE
listing on May 14,1991. Furthermore, the relative spread of
the NYSE issue is also compared to that of the NASDAQ
issue. Our empirical results are consistent with factors such
as security risk, price, trading volume, and the level of
competition suggested by the inventory cost theory in the
determination of relative bid-ask spreads. We also document
a tradeoff between inventory costs and adverse information
in the two exchanges. Our findings suggest that factors
associated with inventory costs and adverse information
theories play important roles in determining the relative
bid-ask spread of the two securities. •
Glosten, Lawrence R. and Paul R. Milgrom, 1985, "Bid, Ask and
Transaction Prices in a Specialist Market with Heterogeneously
Informed Traders," Journal of Financial Economics 14:1 (March),
71-100.
Ho, Thomas and Hans R. Stoll, 1981, "Optimal Dealer Pricing Under
Transaction and Return Uncertainty," Journal of Financial
Economics 35:2 (March), 47-73.
Potter, Gordon, 1992," Accounting Eamings, Announcements, Institutional
Investor Concentration, and Common Stock Returns," Journal of
Accounting Research 30:\ (Spring), 146-155.
Stoll, Hans R., 1978a, "The Supply of Dealer Services in Security Markets,"
Journal of Finance 33:4 (September), 1133-1151.
Stoll, Hans R., 1978b, "The Pricing of Security Dealer Services: An
Empirical Study of NASDAQ Stocks," Journal of Finance 33:4
(September), 1153-1172.
Tinic, Seha M. and Richard R. West, 1972, "Competition and the Pricing
of Dealer Services in the Over-the-Counter Stock Market," Journal of
Financiai and Quantitative Analysis 7:3 (June), 1707-1727.