How Bid-Ask Spreads Affect Volatility Estimates

Summary

The document asks whether bid-ask spreads for power prices can be studied without order book data by simulating price series with preset volatility from an Ornstein–Uhlenbeck process and varying the spread. The response cautions that spread effects and volatility should be considered together rather than treating spread as an independent cost added to an otherwise specified price process.

It points to market microstructure models, including Kyle and Glosten–Milgrom, as frameworks in which volatility influences the spread. It also notes that observed bid-ask spreads can distort volatility estimates and induce negative autocorrelation. The response does not supply a simulation design, calibration procedure, or empirical results, and it does not establish that an Ornstein–Uhlenbeck process is suitable for power prices. The suggested literature is a starting point for understanding spread formation and liquidity, not a direct validation of the proposed experiment.

Key ideas

• Bid-ask spreads can affect estimates of volatility from observed prices.
• Microstructure models link volatility to the formation of bid-ask spreads.
• The presence of a spread can produce negative autocorrelation in observed price changes.
• A simulation using an Ornstein–Uhlenbeck process is not validated by the response and may need microstructure foundations.

Tags

# Simulating Bid-Ask Spreads


# Simulating Bid-Ask Spreads












I would like to examine the impact of the volatility on the transaction costs (Bid-ask spread). In my case I would like to examine this for power prices. However, I don't have access to actual order book data. My approach would be now to test this theoretically by simulating for different bid-ask spread percentages of the prices two series with predetermined volatility (by using an Ornstein-Uhlenbeck process) to then somehow quantify the impact on the volatility. My question is if this approach is somewhat valid or if there are other possibilities.

## Answer by kurtosis (score 2)

https://quant.stackexchange.com/a/57862

If you want to model bid-ask spreads, I suggest you first read up on estimating bid-ask spreads. I have an overview here, but the gist of it is that the bid-ask spread affects estimates of the volatility. Microstructure models such as Kyle (1985) and Glosten and Milgrom (1985) show that the volatility affects the bid-ask spread. Note that none of these presumes an O-U model. Rather, the existence of a bid-ask spread induces a negative autocorrelation. You might want to consult Foucault, Pagano, and Röell's Market Liquidity for more information and background.

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