Journal of Financial Economics 48 (1998) 159188

An empirical examination of the amortized spread1

John M.R. Chalmers!, Gregory B. Kadlec",*
! Lundquist College of Business, University of Oregon, Eugene, OR 97403, USA
" Pamplin College of Business, Virginia Polytechnic Institute, Blacksburg, VA 24061, USA
Received 9 September 1996; received in revised form 29 September 1997

Abstract
Theories of asset pricing suggest that the amortized cost of the spread is relevant to
investors required returns. The amortized spread measures the spreads cost over
investors holding periods and is approximately equal to the spread times share turnover.
We examine amortized spreads for Amex and NYSE stocks over the period 19831992.
We find that stocks with similar spreads can have vastly different share turnover, and
thus, a stocks amortized spread cannot be predicted reliably by its spread alone.
Consistent with theories of transaction costs, we find stronger evidence that amortized
spreads are priced than we find for unamortized spreads. ( 1998 Elsevier Science S.A.
All rights reserved.
JEL classification: G10
Keywords: Transaction costs; Bidask spread; Share turnover

* Corresponding author. Tel.: #1 540 231 4316; fax: #1 540 231 3155; e-mail: kadlec@vt.edu.
1 Prior versions of this paper were entitled, Bidask spreads, holding periods, and realized
transaction costs. We are grateful for many helpful comments from Yakov Amihud, Jennifer
Conrad, Larry Dann, Diane Del Guercio, Dave Denis, Diane Denis, Craig Dunbar, Ed Dyl, Roger
Edelen, Rob Hansen, Mark Huson, Raman Kumar, Chris Lamoureux, John McConnell, Wayne
Mikkelson, Megan Partch, Henri Servaes, Vijay Singal, Mike Weisbach, Marc Zenner, and an
anonymous referee. In addition, we appreciate the comments from seminar participants at the 1997
American Finance Association meetings, the University of Arizona, Kansas State University, the
University of North Carolina, the 1996 Pacific Northwest Finance Conference, Virginia Polytechnic
Institute, and the University of Wisconsin. This work has been partially supported by a summer
research grant from the Pamplin College of Business.
0304-405X/98/$19.00 ( 1998 Elsevier Science S.A. All rights reserved
PII S 0 3 0 4 - 4 0 5 X ( 9 7 ) 0 0 0 0 7 - 5

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1. Introduction
While the role of transaction costs in asset pricing remains the subject of
debate, few would argue with the basic premise that transaction costs affect an
individuals required return. For example, an individuals required return on
a stock will equal his required return in the absence of a bidask spread, plus the
percentage bidask spread amortized over the individuals expected holding
period. The theoretical debate over the importance of transaction costs in asset
pricing arises primarily from differing assumptions regarding investors holding
periods. Amihud and Mendelson (1986) assume that individuals trade for
liquidity purposes with an average holding period of 1.6 years. Under this
assumption, spreads are amortized over relatively short holding periods, and
thus, the amortized cost of transacting is large. As a result, Amihud and
Mendelsons model predicts that bidask spreads have a significant effect on
asset returns. Alternatively, Constantinides (1986) assumes that individuals
trade only to rebalance their portfolios. Under this assumption, spreads are
amortized over relatively long holding periods, and thus, the amortized cost of
transacting is small. Consequently, Constantinides model predicts that bidask
spreads have only a second-order effect on asset returns.2
Empirical studies of the relation between stock returns and bidask spreads
have not resolved this debate. Amihud and Mendelson (1986) find a significant
positive relation between stock returns and bidask spreads, while Chen and
Kan (1989) find an insignificant relation and Eleswarapu and Reinganum (1993)
find that the relation between stock returns and bidask spreads is significant
only in the month of January. However, these studies focus solely on the
magnitude of the spread without consideration of the length of the holding
period over which spreads are amortized. For example, Amihud and Mendelson
(1986), Chen and Kan (1989), and Eleswarapu and Reinganum (1993) all use
closing bidask spreads as a proxy for the expected cost of the spread. If stocks
with similar spreads trade with different frequency, the magnitude of the spread
is not a sufficient proxy for the amortized cost of the spread.
We examine amortized spreads, which explicitly capture both the magnitude
of the spread and the length of investors holding periods. We define the
amortized spread as the product of the effective spread and the number of shares
traded summed over all trades for each day and expressed as an annualized
fraction of equity value. Intuitively, the amortized spread measures the annualized cost of the spread to investors and is approximately equal to the
effective spread times share turnover. We compute amortized spreads for the

2 For other theories of optimal investment policy and asset pricing under transaction costs see, i.e.,
Brennan (1975), Goldsmith (1976), Levy (1978), Milne and Smith (1980), Mayshar (1981), Aiyagari
and Gertler (1991), and Vayanos and Vila (1995).

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161

universe of U.S. domiciled common stocks listed on either the Amex or NYSE at
any time during the period 19831992.
We find that, while the average round-trip effective spread of Amex/NYSE
stocks is 2.2% of equity value, the average annual amortized spread is only 0.5%
of equity value. More importantly, because stocks with similar spreads can have
vastly different share turnover, a stocks amortized spread cannot be predicted
reliably by its spread alone. For example, transportation stocks have lower
effective spreads than stocks of firms in consumer goods, financial, capital goods,
and basic goods. However, due to their higher share turnover, transportation
stocks have higher amortized spreads than stocks in any of these industries.
Our analysis of the determinants of the amortized spread reveals that a stocks
amortized spread is strongly related to its return volatility, a variable that is
positively related to both spreads and share turnover. For example, utility
stocks, which have relatively low return volatility, have both low spreads and
low share turnover, and thus, low amortized spreads. By contrast, technology
stocks, which have relatively high return volatility, have both high spreads and
high share turnover, and thus, high amortized spreads.
We argue that, in the context of asset pricing, the amortized spread is a more
relevant measure of transaction costs than the spread. Consistent with this view,
we find stronger evidence that amortized spreads are priced than we find for
spreads. However, we interpret these asset pricing results with caution due to the
limited sample period (19831992) over which the tests are conducted. Given the
current interest in market value of equity and book-to-market as factors in
security returns, we also examine the relation between amortized spreads and
these two variables. Although amortized spreads are negatively related to
market value of equity and positively related to book-to-market, multivariate
asset pricing tests show that the explanatory power of the amortized spread is
not subsumed by market value of equity or market-to-book.
The remainder of the paper is organized as follows. Section 2 defines our
measure of the amortized spread and describes the data that are used to
calculate it. Section 3 reports cross-sectional and time-series descriptive statistics of amortized spreads. In Section 4, we examine determinants of the amortized spread. In Section 5, we estimate the relation between stock returns and
two alternative measures of spread-related transaction costs, amortized spreads
and unamortized spreads. Section 6 summarizes our findings and discusses their
implications. The Appendix provides details concerning the methodology used
in the asset pricing tests.

2. Amortized spreads
In this section we formally define our measure of the amortized spread and
describe the data that we use to calculate the amortized spread.

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2.1. Calculating amortized spreads

To calculate amortized spreads, we first measure the total dollar amount
expended on bidask spreads for each sample stock on each trading day.
Following Blume and Goldstein (1992) and Lee (1993), define P as the transact
tion price and M as the midpoint of the prevailing bidask quote. A stocks
t
daily dollar spread is defined as the sum, over all trades, t"1, . . . , , of the
product of the absolute value of the effective spread, DP !M D, and the number
t
t
of shares traded, . The daily amortized spread for day is equal to the daily
t
dollar spread scaled by the firms market value of equity at the end of day
(P x SharesOut ),
T
T
+T DP !M D )
t
t.
AS " t/1 t
T
P ) SharesOut
T
T

(1)

For expositional purposes, we annualize daily amortized spreads by multiplying

the daily amortized spread by 252 trading days per year. The calculation of daily
amortized spreads involves an average of 50 transactions per day for 2000 firms
over 2520 trading days or roughly 250 million transactions. To keep our data
sets manageable, we work with monthly averages of the annualized daily
amortized spreads.
Eq. (1) is related to Amihud and Mendelsons (1986) spread-adjustment
factor kS, where 1/k is the expected holding period and S is the relative spread.
From Eq. (1), a stocks amortized spread is approximately equal to the effective
spread times share turnover,
DP!MD

AS+
)
,
P
SharesOut

(2)

which is also the effective spread divided by the average holding period (1/turnover). Thus, a stock which has an effective spread of 4% and annual turnover of
50% would have an annual amortized spread of 2%. If expected gross returns
include reimbursement for expected transaction costs, cross-sectional differences
in amortized spreads provide a benchmark for assessing the potential impact of
bidask spread-related transaction costs on security returns.
The amortized spread in Eq. (1) has several important features as a measure of
transaction costs. First, it is calculated with effective spreads rather than quoted
spreads. Theoretical models of the bidask spread, such as Amihud and Mendelson (1980), Ho and Stoll (1981), and Glosten and Milgrom (1985) typically
analyze the specialists quoted spread. However, it is the effective spread at
which investors conduct trades, and thus is the more relevant measure for

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163

computing transaction costs.3 Blume and Goldstein (1992), Lee (1993), and
Petersen and Fialkowski (1994) find that the effective spread is approximately
5070% of the specialists quoted spread. More importantly, Petersen and
Fialkowski (1994) report that the cross-sectional correlation between the effective spread and the quoted spread is less than 0.31.
Second, Eq. (1) incorporates investors holding periods since it is calculated
from actual trades. The length of investors expected holding periods determines
the spreads impact on required returns. For example, Barclay and Smith (1988)
show that an individuals required return on a stock can be expressed as the
required rate of return in the absence of a spread plus the percentage bidask
spread amortized over the investors expected holding period. Thus, the shorter
the expected holding period, the greater the impact of the bidask spread on an
individuals required return.
Third, our measure of the amortized spread implicitly incorporates the depth
of the spread quote. Lee et al. (1993) argue that no measure of the spread is truly
meaningful without information concerning its depth. Eq. (1) incorporates the
constraint imposed by the depth of quote because it measures the cost of
completed trades.
There are some potential limitations of our measure. First, the amortized
spread reflects only transaction costs associated with the bidask spread. Other
costs of transacting may also be priced, such as brokerage fees, commissions,
and price movement. Second, while the impact of bidask spreads on required
returns is determined by expected holding periods, our measure of the amortized
spread reflects realized holding periods. This limitation is important if a stocks
amortized spread is driven largely by unanticipated shocks to turnover. To
address this concern, we provide evidence which suggests that a stocks amortized spread is relatively stable over time. Finally, our measure of the amortized
spread reflects the average holding period of all investors. If a large portion of
a firms stock is held by an individual with an unusually long holding period, our
measure may understate the amortized spread for the marginal investor. Notwithstanding these important qualifications, we believe that, in the context of
asset pricing, our measure of the amortized spread is a more relevant measure of
transaction costs than the simple magnitude of the spread.

3 The effective spread measure as defined by Blume and Goldstein (1992) and Lee (1993) and used
here to compute amortized spreads has at least two limitations as a measure of the cost of the spread.
First, to the extent that the specialists quotes lie asymmetrically about the true price the effective
spread measure, which compares transaction prices to the midpoint of the bidask quote, may either
understate or overstate the true spread. Though, there is no reason to believe that this source of error
results in biased estimates. Second, if a market order is matched directly with another market order
the effective spread measure will overstate the actual cost of the spread (which on average is zero).
However, Hasbrouck (1988) suggests that such occurrences are rare.

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2.2. The data

Our sample includes the universe of U.S. domiciled common stocks listed on
either the Amex or the NYSE at any time during the period 19831992. Data for
computing effective spreads and amortized spreads are obtained from the
Institute for the Study of Security Markets (ISSM) transactions files. We use
only Best Bid/Offer (BBO) eligible quotations and exclude certain quotes and
transactions that are identified by ISSM as erroneous. In addition, ISSM
identifies quotations and transactions that are atypical. We exclude all quotes
identified as pre-opening indications, trading halts and non-firm quotations and
all trades that are identified as either batched, executed as part of a basket trade,
or reported out of sequence. In addition to the filters provided by ISSM, we
apply additional filters to remove observations that may be subject to data entry
errors. Following Keim (1989) and Blume and Goldstein (1992), we eliminate
any bidask quote that is greater than 20% of the stock price for stocks priced
over $10 dollars and greater than $2 for stocks priced under $10. We also
eliminate transactions that occur following a quotation that was eliminated and
prior to a new quote. As Lee and Ready (1991) suggest, we adjust for errors in
the time stamp of quotations. The time stamp adjustments are necessary due to
the differential delays in the reporting of quotes and transactions. Finally, we
eliminate Berkshire Hathaway and Capital Cities because of their unwieldy
stock prices. Collectively, these screens eliminate less than 10% of all trades by
volume. Data for computing market value of equity and share turnover are
taken from the Center for Research in Security Prices (CRSP) daily return files.
We exclude observations in which daily share turnover is greater than 20% of
the firms outstanding shares to avoid large errors in share turnover due to
delays in updating shares outstanding following stock splits and stock issues.
This screen eliminates fewer than 0.01% of the total observations.

3. Characteristics of the amortized spread

In this section, we examine cross-sectional and time-series characteristics of
annualized amortized spreads calculated using Eq. (1).
3.1. Cross-sectional properties
Table 1 reports pooled cross-sectional time-series descriptive statistics of the
amortized spread, and its two components, the effective spread and share
turnover. In panel A, stocks are assigned to deciles on the basis of their average
monthly amortized spread rank. In panel B, stocks are assigned to deciles on the
basis of their average monthly effective spread rank. In panel C, stocks are
assigned to deciles on the basis of their average monthly share turnover rank.

0.29%
0.43%
0.67

0.44%
1.46%
0.33

Panel C: Deciles formed by share turnover

Amortized spread
0.21%
0.30%
Effective spread
1.84%
1.50%
Share turnover
0.13
0.23

Panel B: Deciles formed by effective spread

Amortized spread
0.19%
0.24%
Effective spread
0.25%
0.35%
Share turnover
0.73
0.66

0.21%
0.67%
0.46

Low

Panel A: Deciles formed by amortized spread

Amortized spread
0.09%
0.15%
Effective spread
0.51%
0.56%
Share turnover
0.23
0.37

Decile

0.44%
1.22%
0.41

0.34%
0.53%
0.63

0.28%
0.74%
0.53

0.51%
1.09%
0.51

0.42%
0.66%
0.63

0.34%
0.84%
0.60

0.58%
0.98%
0.61

0.50%
0.80%
0.64

0.44%
1.00%
0.68

0.59%
0.91%
0.71

0.56%
0.98%
0.60

0.56%
1.20%
0.73

0.60%
0.77%
0.81

0.71%
1.43%
0.54

0.78%
1.62%
0.78

0.63%
0.65%
1.02

0.88%
2.26%
0.47

0.99%
1.92%
0.84

0.82%
0.59%
1.48

1.17%
4.16%
0.37

1.76%
2.81%
1.03

High

0.51%
1.11%
0.60

0.51%
1.11%
0.60

0.51%
1.11%
0.60

Avg.

Panels A, B and C present cross-sectional and time-series averages of the amortized spread and its components, the effective spread and share turnover for
all U.S. based stocks traded on the Amex or NYSE at any time during the period from 19831992. A stocks amortized spread is the product of the effective
spread and the number of shares traded summed over all trades and expressed as an annual percent of equity value. The effective spread is the difference
between the transaction price and the midpoint of the prevailing bidask quote. Share turnover is equal to the annual share volume divided by the number
of shares outstanding. In panel A, stocks are assigned to deciles based upon their average monthly amortized spread rank. In panel B, stocks are assigned
based upon their average monthly effective spread rank. In panel C, stocks are assigned based upon their average monthly share turnover rank. In each
case, decile 1 refers to the lowest values of the ranking variable and decile 10 are stocks that exhibit the largest values for the ranking variable.

Table 1
Average amortized spreads, effective spreads, and share turnover

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165

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J.M.R. Chalmers, G.B. Kadlec/Journal of Financial Economics 48 (1998) 159188

For example, to construct panel A, we assign each stock an amortized spread

rank for each month of the sample period for which at least 10 days of data are
available for that stock. We then assign each stock to an amortized spread decile
on the basis of the stocks average monthly rank during the stocks sample
period. We use this approach for two reasons. First, assigning stocks to deciles
on the basis of their average rank as opposed to the average value of the ranking
variable mitigates potential misclassifications due to time series variation in the
level of the ranking variable. This is necessary because many stocks are not
present for the entire sample period. Second, assigning firms to deciles on
a one-time basis as opposed to yearly or monthly allows for a more straightforward interpretation of the results, i.e., deciles contain stocks as opposed to
stock-years or stock-months. However, our conclusions are not sensitive to the
choice of the ranking procedure.
Table 1 documents several facts. First, in contrast to the magnitude of the
round-trip spread, the amortized spread is quite small. From panel A, the
average round-trip effective spread for our sample stocks is 2.2% of equity value,
twice the average one-way effective spread, while the average annual amortized
spread is only 0.5% of equity value. Furthermore, 88% of all sample stocks have
amortized spreads of less than 1%. Thus, if a primary component of security
returns is reimbursement for transaction costs, one would expect to find less
than a 1% difference among the annual returns of most Amex/NYSE stocks and
a 1.7% difference between the annual returns of stocks in deciles one and ten.
The distribution of amortized spreads differs somewhat across the two exchanges. The average amortized spread is 0.67% for Amex stocks and 0.46% for
NYSE stocks. The t-statistic for a test of equal means for the amortized spreads
of Amex versus NYSE stocks is 8.8 with a p-value less than 0.0001. The
statistically significant difference in mean amortized spreads between Amex and
NYSE stocks is not due to a few extreme values. A large proportion of Amex
firms are found in the high amortized spread deciles. For example, while Amex
stocks represent 33% of the sample, they account for 47% of the stocks in
deciles nine and ten. The s2 statistic, against the null that Amex stocks are
distributed uniformly across the amortized spread deciles, is 56 (p(0.0001).
Second, much of the cross-sectional variation in amortized spreads is lost
when effective spreads are used as a proxy for the amortized spread. For
example, the interdecile range of amortized spreads drops from 1.7%, when
stocks are sorted by the amortized spread (panel A), to less than 1% when stocks
are sorted by the effective spread (panel B). Though not reported in Table 1, the
interdecile range of amortized spreads is less than 0.9% when stocks are sorted by
their average closing quoted spread. While a 0.9% difference in annual returns is
certainly of economic importance, it is unlikely that current asset pricing tests can
reliably detect it. In other words, the lack of variation in amortized spreads
coupled with the use of a limited proxy, i.e., quoted spreads, may explain the
rather weak evidence of a spread effect in the returns of Amex/NYSE stocks.

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167

To more formally assess the relation between amortized spreads and effective
spreads, we estimate the Pearson and Spearman correlation between amortized
spreads and effective spreads. The cross-sectional correlations between average
amortized spreads and average effective spreads are 0.54 (Pearson) and 0.59
(Spearman). The imperfect correlation between amortized spreads and effective
spreads is due to the fact that not all stocks with the same spread trade with the
same frequency. In Amihud and Mendelsons (1986) framework, there is a perfect correlation between spreads and amortized spreads because all stocks with
the same spread trade with the same frequency. This feature of Amihud and
Mendelsons (1986) model is not supported by the data in Table 1. If all stocks
with the same spread traded with the same frequency, deciles formed by spread
(panel B) would be the exact inverse of deciles formed by turnover (panel C).
This is not the case. For example, the average spread of the highest spread decile
(panel B) is 4.16%, while the average spread of the lowest share turnover decile
(panel C) is 1.84%.
Finally, it is interesting to note that stocks with high amortized spreads have
both high effective spreads and high share turnover, while stocks with low
amortized spreads have both low effective spreads and low share turnover.
From panel A, stocks in the highest amortized spread decile have average
effective spreads of 2.8% and average share turnover of 103%, while stocks in
the lowest amortized spread decile have average effective spreads of 0.5% and
average share turnover of 23%. The positive association between spread and
share turnover in panel A is in contrast to Amihud and Mendelsons (1986)
clientele effect, whereby stocks with higher spreads are held for longer periods
than stocks with lower spreads.
Fig. 1 provides a more detailed view of the surface of amortized spreads in the
dimensions of the effective spread and share turnover. Panel A displays the
average amortized spread for stocks falling into the various spread ranks (from
panel B of Table 1) and share turnover ranks (from panel C of Table 1). The
number of stocks in each cell is presented in panel B of Fig. 1. As previously
noted, there is little variation in amortized spreads across most stocks. Note that
the only stocks with markedly different amortized spreads are found in the high
spread/high turnover region of Fig. 1A. Fig. 1B reveals that few stocks fall into
this category. Furthermore, stocks with similar spreads can have vastly different
amortized spreads because of differences in share turnover. For example, in
spread rank ten, the average effective spread is 4.16%, yet these stocks average
amortized spreads range from 0.5% to 3.5%. Likewise, due to differences in
turnover, stocks with vastly different spreads can have similar amortized
spreads. For example, in spread rank ten, turnover rank one, we find 92 stocks
with average amortized spreads of 0.50%, and in spread rank one, turnover rank
ten, we find 57 stocks with average amortized spreads of 0.37%. Table 1 and
Fig. 1 provide evidence that stocks with similar spreads can exhibit vastly
different amortized spreads and stocks with vastly different spreads can exhibit

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Fig. 1. The surface of amortized spreads. A stocks amortized spread is the product of the effective
spread and the number of shares traded summed over all trades and expressed as an annualized
percent of equity value. The effective spread is the difference between the transaction price and the
prevailing bidask midpoint. Share turnover is equal to the annualized volume of shares traded
divided by the number of shares outstanding. In panels A and B, stocks are assigned to effective
spread/share turnover cells based upon their average monthly effective spread rank and their
average monthly share turnover rank. The sample includes U.S. based stocks traded on either the
Amex or NYSE from 19831992. In each case, decile 1 refers to the lowest values of the ranking
variable and decile 10 includes stocks that exhibit the largest values for the ranking variable.

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169

similar amortized spreads. This is why one cannot infer the amortized cost of
transacting on the basis of the spread alone.
3.2. Time-series properties
The ranking procedure we use to form the deciles in Table 1 is designed to
capture a stocks long run amortized spread. However, this ranking method will
obscure variation in the amortized spreads of individual stocks over time.
A natural question concerns the stability of a stocks amortized spread over
time. To address this question, we provide several pieces of evidence.
Fig. 2 plots the time-series of monthly amortized spreads for stocks assigned
to deciles on the basis of their amortized spread rank in 1983. For clarity, we
focus on amortized spread deciles one and ten. We compare the amortized
spread of deciles one and ten to the average amortized spread of all stocks in
each sample month. The relative stability of a stocks amortized spread is
immediately apparent. In particular, the amortized spreads for deciles one and
ten never revert to the average amortized spread over the ensuing nine year
period.4 This simple experiment shows that, even over a protracted period of
time, a stocks amortized spread is relatively stable.
To more formally assess the stability of a stocks amortized spread over time,
we estimate the correlation between a stocks average amortized spread in year
t and its average amortized spread in year t!1. Over the 10 year period from
1983 to 1992, the average of the nine correlation coefficients is 0.56. The average
correlation between a stocks amortized spread rank in year t and its amortized
spread rank in year t!1 is 0.81. To determine whether the stability of the
amortized spread is due to the stability of the effective spread or the stability of
a stocks share turnover, we repeat the above analysis for the effective spread
and share turnover. The average of the nine correlation coefficients between
a stocks average effective spread in year t and its average effective spread in year
t!1 is 0.75. The average correlation between a stocks effective spread rank in
year t and its effective spread rank in year t!1 is 0.93. The average of the nine
correlation coefficients between a stocks average share turnover in year t and its
average share turnover in year t!1 is 0.65. The average correlation between
a stocks share turnover rank in year t and its share turnover rank in year t!1
is 0.79.
Finally, we examine the correlation of a stocks amortized spread, effective
spread, and share turnover between two five year sub-periods (19831987 and
19881992). The correlation coefficient for a stocks average amortized spread,

4 In 1983, decile 1 includes a maximum of 214 firms and finishes the 10 year period with 139 firms.
Likewise, decile 10 includes a maximum of 219 firms in 1983 and finishes the 10 year period with 85
firms. The monthly average amortized spread is calculated from an average of 1988 stocks.

Fig. 2. Stability of the amortized spread. Monthly average amortized spreads of U.S. domiciled stocks traded on NYSE or Amex are plotted from January
1983 through December 1992. A stocks amortized spread is the product of the effective spread and the number of shares traded summed over all trades
and expressed as an annualized percent of equity value. Amortized spread deciles one and ten include the stocks with the lowest and highest, respectively,
average monthly amortized spread rank in 1983. The monthly mean amortized spread is plotted for the surviving firms from deciles one and ten over the
entire 120 month period, with the first twelve months being the ranking period. The average amortized spread for all sample firms in each month is
presented for reference. The average number of firms used in the calculation of the average amortized spread is 1976. Decile 1 includes a maximum of 214
firms in 1983 and finishes the 10 year period with 139 firms. Decile 10 includes a maximum of 219 firms in 1983 and finishes the 10 year period with 85 firms.

170
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171

effective spread, and share turnover between these two periods are 0.52, 0.55 and
0.51, respectively. The correlation for a stocks amortized spread rank, effective
spread rank, and share turnover rank between these two periods are 0.78, 0.86,
and 0.74, respectively. These results suggest that there are persistent factors
which influence a stocks amortized spread.

4. Determinants of the amortized spread

Researchers have examined the determinants of the bidask spread and
determinants of trade separately. The theoretical literature on bidask spreads
has identified order processing, inventory control, and adverse selection costs as
three primary components to the spread. The general empirical implications of
these theories are that bidask spreads are negatively related to share turnover
and share price and positively related to stock return variance.5 The theoretical
literature on trading volume has examined a number of motives for trade,
including liquidity, portfolio rebalancing, tax-loss selling, asymmetric information, and differences of opinion. According to theories of trade, frequency of
trade is negatively related to the bidask spread and positively related to stock
return variance.6 Because the amortized spread is determined by the interaction
of the spread and frequency of trade, the net effect of these factors on the
amortized spread is unclear.
Table 2 reports coefficient estimates for cross-sectional regressions of effective
spreads, share turnover, and the amortized spread on the determinants of
spreads and share turnover. Panel A reports coefficient estimates from regressions of the effective spread on stock price, stock return variance and share
turnover. Panel B reports coefficient estimates from regressions of share turnover on stock return variance and the effective spread. Panel C reports coefficient estimates from regressions of the amortized spread on stock price and stock
return variance. We use time-series means of stock prices, share turnover,
effective spreads, and amortized spreads, and calculate return variance from
monthly returns over each stocks available sample period. We use logarithmic
transformations of these variables to eliminate skewness that is present in the
raw data.

5 For theories of the bidask spread see Demsetz (1968), Treynor (1971), Amihud and Mendelson
(1980), Ho and Stoll (1981), Glosten and Milgrom (1985). For empirical evidence see Bensten and
Haggerman (1974), Stoll (1989), Glosten and Harris (1988), and George et al. (1991).
6 For theories of trade see Constantinides and Ingersoll (1984), Kyle (1985), Karpoff (1986),
Constantinides (1986) and Harris and Raviv (1993). For empirical evidence see Atkins and Dyl
(1997a), Bessembinder et al. (1996).

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J.M.R. Chalmers, G.B. Kadlec/Journal of Financial Economics 48 (1998) 159188

Table 2
Determinants of spreads, turnover, and amortized spreads
Table 2 reports coefficient estimates for cross-sectional regressions of effective spreads, share
turnover, and the amortized spread on share price, return volatility, and spreads or share turnover
where applicable. Panel A reports coefficient estimates from regressions of the effective spread on
stock price, stock return variance and share turnover. Panel B reports coefficient estimates from
regressions of share turnover on stock return variance and the effective spread. Panel C reports
coefficient estimates from regressions of the amortized spread on stock price, and stock return
variance. For each cross-sectional observation, we use time-series means of stock prices, share
turnover, effective spreads, and amortized spreads, and calculate return variance from monthly
returns over each stocks available sample period. We use logarithmic transformations of the
variables. Standard errors are presented in parentheses. Each of the coefficient estimates has an
associated p-value less than 0.01.
Panel A: Dependent variable effective spread
Intercept

Turnover

Price

Return variance

Adj-R2

!2.06
(0.02)

!0.14
(0.01)

!0.70
(0.01)

0.24
(0.01)

0.91

3366

Panel B: Dependent variable share turnover

Intercept

Effective spread

Return variance

Adj-R2

!1.58
(0.07)

!0.71
(0.02)

0.60
(0.02)

0.28

3366

Panel C: Dependent variable amortized spread

Intercept

Price

Return variance

Adj-R2

!2.59
(0.06)

!0.24
(0.02)

0.56
(0.02)

0.48

3366

We begin with the cross-sectional relation between effective spreads and stock
price, stock return variance, and share turnover. The coefficients reported in
panel A are consistent with prior studies of the determinants of the spread. In
particular, the coefficient of stock price is negative (!0.70) and significant
(p-value(0.0001), the coefficient of stock return variance is positive (0.24) and
significant (p-value(0.0001) and the coefficient of share turnover is negative
(!0.14) and significant (p-value(0.0001). Though not reported in Table 2,
coefficient estimates from regressions of quoted bidask spreads on share price,
volatility, and share turnover are nearly identical to those reported in panel A.

J.M.R. Chalmers, G.B. Kadlec/Journal of Financial Economics 48 (1998) 159188

173

Panel B reports coefficient estimates from regressions of share turnover on

stock return variance and spread. The coefficients reported in panel B are
consistent with prior studies of the determinants of trade. In particular, the
coefficient of stock return variance is positive (0.60) and significant
(p-value(0.0001) and the coefficient of the spread is negative (!0.71) and
significant (p-value(0.0001).
Having examined the determinants of effective spreads and share turnover
separately, we now turn to the cross-sectional relation between amortized
spreads and the determinants of spread and share turnover. Because amortized
spreads are an explicit function of both spread and share turnover, we do not
include either of these as independent variables in the regressions.7 Panel
C reports coefficient estimates for regressions of amortized spreads on stock
price and stock return variance. Because stock price appears only in the
regression for spread and has a negative coefficient, we expect a negative relation
between amortized spreads and stock price. The expected relation between
amortized spreads and return volatility is unclear. Since both spread and share
turnover are positively related to return volatility, one might expect to observe
a positive relation between amortized spreads and return volatility. However,
because of the negative relation between spread and turnover, the expected
association between return volatility and the amortized spread is ambiguous.
From panel C, the coefficient of stock price is negative (!0.24) and significant (p-value(0.0001) as expected. The coefficient of return volatility is positive
(0.56) and significant (p-value(0.0001). The positive coefficient of return vola
tility suggests that the positive effect that volatility has on spread and share turnover
outweighs the negative effect that spread and turnover have on each other.
Table 3 provides additional information concerning the relation between
amortized spreads and return volatility by reporting the distributions of amortized spreads for stocks assigned to deciles on the basis of their return volatility.
More specifically, for each volatility decile we report the number of stocks that
fall into each of the amortized spread deciles of Table 1.
The relation between amortized spreads and volatility in Table 3 is striking.
For example, 63% of stocks in the lowest volatility decile fall into the lowest two
amortized spread deciles, while 58% of stocks in the highest volatility decile fall
into the highest two amortized spread deciles. In fact, return volatility appears
to be a better proxy for the amortized spread than the effective spread. The
interdecile range of amortized spreads across volatility deciles is 1.2%, while
Table 1 panel B shows that the interdecile range of amortized spreads across
effective spread deciles is less than 1.0%.

7 Given the fact that the spread and turnover are functions of one another, the regressions of
panels A and B have an endogeneity problem. We do not attempt to resolve this issue. We report the
results of regression that are similar to prior studies.

38%
25%
17%
9%
5%
2%
3%
0%
1%
0%

0.17%
0.38%
0.45
5.96%

Decile mean:
Amortized spreads
Effective spread
Turnover
Standard deviation of return

Low
volatility

0.20%
0.45%
0.53
7.89%

21%
21%
18%
16%
12%
6%
4%
1%
0%
0%

Volatility decile

Low
2
3
4
5
6
7
8
9
High

Amortized spread decile

0.26%
0.51%
0.62
9.03%

10%
17%
18%
20%
18%
9%
6%
2%
1%
1%

0.33%
0.61%
0.65
10.08%

10%
11%
12%
13%
17%
14%
12%
6%
3%
1%

0.38%
0.76%
0.65
11.17%

7%
10%
10%
15%
13%
19%
12%
9%
5%
2%

0.45%
0.85%
0.71
12.39%

5%
6%
9%
8%
11%
17%
16%
18%
7%
3%

0.60%
1.08%
0.78
13.88%

2%
4%
7%
6%
8%
11%
19%
14%
18%
11%

0.78%
1.62%
0.73
15.80%

3%
1%
4%
6%
6%
11%
11%
16%
21%
19%

1.04%
2.25%
0.76
18.78%

1%
1%
2%
3%
4%
6%
10%
20%
22%
30%

1.40%
3.50%
0.68
27.84%

1%
2%
2%
3%
6%
6%
7%
15%
24%
34%

High
volatility

For the stocks in each volatility decile, we report the percentages that are found in each of the amortized spread deciles defined in Table 1. In addition,
mean amortized spreads, effective spreads, share turnover and standard deviation of monthly returns are reported for each volatility decile. A stocks
amortized spread is the product of the effective spread and the number of shares traded summed over all trades and expressed as an annual percent of
equity value.

Table 3
Return volatility and the amortized spread

174
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J.M.R. Chalmers, G.B. Kadlec/Journal of Financial Economics 48 (1998) 159188

175

Table 4
Industry profiles of the amortized spread
For each industry, we report the percentage of stocks within that industry that fall into each of the
amortized spread deciles defined in Table 1. The industry classification scheme is based upon Roll
(1992) with the exception of technology, which Roll (1992) does not define. In addition, mean
amortized spreads, effective spreads, share turnover and standard deviation of monthly returns are
reported for each industrial classification. A stocks amortized spread is the product of the effective
spread and the number of shares traded summed over all trades and expressed as an annual percent
of equity value. The number of firms within each industrial classification is reported directly below
the classification label.
Amortized
spread decile

Low
2
3
4
5
6
7
8
9
High
Industry mean:
Amortized
spreads
Effective spread
Turnover
Standard deviation of return

Industry classification (number of firms)

Technology Transport Consumer Financial Capital Basics Utilities
(271)
(85)
(1129)
(494)
(359) (717) (282)

Energy
(32)

3%
4%
4%
7%
7%
10%
10%
14%
21%
20%

6%
2%
11%
6%
6%
7%
15%
19%
13%
15%

8%
10%
9%
9%
10%
10%
11%
11%
10%
11%

16%
10%
10%
13%
10%
9%
8%
9%
9%
7%

5%
7%
12%
9%
12%
10%
14%
11%
9%
10%

28%
16%
13%
16%
13%
3%
9%
0%
0%
3%

0.73%

0.67%

0.59%

0.55%

0.55% 0.53% 0.34%

0.26%

1.28%
0.86
0.16

1.02%
0.91
0.13

1.19%
0.68
0.14

1.15%
0.62
0.13

1.15% 1.36% 0.61%

0.68
0.58
0.55
0.13
0.14
0.09

0.50%
0.53
0.09

10%
10%
10%
10%
11%
13%
10%
10%
9%
8%

21%
20%
17%
13%
7%
6%
5%
4%
4%
5%

Table 3 also highlights how a stocks return volatility can dominate

the negative relation between spread and turnover. In particular, both spread
and turnover increase as one moves across volatility deciles. For example,
the lowest volatility decile contains stocks with an average effective spread of
0.4% and average share turnover of 45%, while the highest volatility decile
contains stocks with an average effective spread of 3.4% and average share
turnover of 68%.
A less direct, yet more intuitive, way to characterize a stocks return volatility
is by the assets of the issuing firm. Table 4 reports distributions of amortized
spreads for the stocks of different industries. Our industry classifications are
based on Roll (1992) and include: capital goods, basic goods, consumer goods,

176

J.M.R. Chalmers, G.B. Kadlec/Journal of Financial Economics 48 (1998) 159188

utilities, energy, transportation, financial, and technology.8 For each industry,

we report the percent of stocks within that industry that fall into each of the
amortized spread deciles of Table 1.
In Table 4, we find evidence that a firms assets influence both spreads and
frequency of trade, and thus, the amortized cost of transacting. For example,
utilities which are characterized by relatively stable cash flows and substantial
assets in place have both low spreads and low share turnover. By contrast,
technologies, which are characterized by relatively volatile cash flows and
substantial growth opportunities, have both high spreads and high turnover.
From Table 4, utility stocks have an average monthly standard deviation of
return of 9%, average effective spreads of 0.6%, and average share turnover of
55%, while technology stocks have an average monthly standard deviation
of return of 16%, average effective spreads of 1.3%, and average share turnover
of 86%. The positive relation between spread and turnover in Tables 3 and 4 is
inconsistent with Amihud and Mendelsons clientele effect. These results suggest
that return volatility and the characteristics of a firms assets are good proxies
for, and perhaps important determinants of, amortized spreads.
Table 4 also illustrates that a stocks amortized spread cannot be predicted
reliably by its spread alone. For example, transportation stocks have lower
effective spreads than stocks of firms in basic goods. However, due to their
higher share turnover, transportation stocks have higher amortized spreads
than basic goods stocks. From Table 4, the average effective spread for transportation stocks and basic goods stocks are 1.0% and 1.4% (t-statistic for
difference in means is 2.37), while the average annual amortized spread for
transportation stocks and basic goods stocks are 0.67% and 0.53% (t-statistic
for difference in means is 2.10) A number of similar examples can also be found
in Table 4.

5. Stock returns and the amortized spread

The empirical results in Sections 3 and 4 show that the magnitude of the
spread is not always a reliable proxy for the amortized cost of the spread. In this
section we compare the relative merits of amortized spreads and unamortized
spreads in the context of asset pricing. First, we examine the relation between
amortized spreads and market value of equity and book-to-market, two variables which are currently important in empirical studies of asset pricing.
8 Roll (1992), defines seven industry categories: capital goods, basis goods, utilities, energy,
transportation, and financial. We assign technology stocks to their own category, and thus, have
eight industry categories. We define technologies to be stocks in firms whose primary lines of
business include: computer and office equipment, communications equipment, electronic components, electronic measurement and navigational instruments, and computer software.

J.M.R. Chalmers, G.B. Kadlec/Journal of Financial Economics 48 (1998) 159188

177

5.1. Amortized spreads, market value of equity, and book-to-market

Banz (1981) and Reinganum (1981) find that stock returns are negatively
related to market value of equity, while Stattman (1980) and Rosenberg et al.
(1985) find that stock returns are positively related to book-to-market. Fama
and French (1992) argue that market value of equity and book-to-market may
be related to risk factors that are not captured by a stocks beta. Alternatively,
Amihud and Mendelson (1986) and Kothari et al. (1995) argue that these
variables may be related to a stocks liquidity premium. Because the amortized
spread is a direct measure of a stocks liquidity, it is interesting to examine the
relations between amortized spreads, market value of equity and book-tomarket.
Table 5 reports the distribution of amortized spreads across market value of
equity deciles and Table 6 reports the distribution of amortized spreads across
book-to-market deciles. From Table 5, we find a negative relation between the
amortized spread and market value of equity. For example, the average amortized spread for stocks in the lowest market value decile is 1%, while the average
amortized spread for stocks in the highest market value decile is 0.20%. The
cross-sectional correlation between amortized spread and market value of
equity is !0.20 (Pearson) and !0.43 (Spearman).
From Table 6, we find a positive relation between amortized spread and
book-to-market. For example, the average amortized spread for stocks in the
lowest book-to-market decile is 0.48%, while the average amortized spread for
stocks in the highest book-to-market decile is 0.63%. The cross-sectional correlation between a stocks amortized spread and book-to-market are 0.15
(Pearson) and 0.16 (Spearman). These results indicate that amortized spreads
are related to both market value of equity and book-to-market. However, the
relatively low correlation between these variables suggests that market value of
equity and book-to-market are unlikely to be proxies for the amortized spread.
5.2. Cross-sectional regressions
To estimate the relation between stock returns and our two alternative
measures of transactions costs, we use the cross-sectional regression approach of
Fama and MacBeth (1973). For each year, t, we estimate variants of the
following cross-sectional regression:
r "c #c b #c ME
#c (B/M)
#c p
jt
0t
1t j
2t
j,t~1
3t
j,t~1
4t j,t~1
#c C
#e ,
(3)
5t j,t~1
j,t
where r is the excess return of security j over the one-year Treasury bill, b is the
jt
j
market risk of security j, ME
is the natural log of market value of equity of
j,t~1
security j measure in the year t!1, (B/M)
is equal to the ratio of the end of
j,t~1

2%
3%
4%
5%
8%
10%
9%
15%
18%
26%

1.00%
3.41%
0.39
9

Decile mean:
Amortized spreads
Effective spread
Turnover
Market value
(millions)
0.77%
2.07%
0.48
22

4%
7%
8%
9%
11%
7%
11%
10%
17%
16%

Small firms 2

Size decile

Low
2
3
4
5
6
7
8
9
High

Amortized
spread decile

0.76%
1.72%
0.55
42

5%
8%
6%
10%
6%
7%
16%
15%
13%
14%

0.62%
1.20%
0.60
73

10%
7%
10%
7%
11%
7%
9%
16%
12%
10%

0.57%
0.90%
0.71
124

11%
8%
9%
8%
6%
12%
8%
13%
10%
15%

0.49%
0.73%
0.72
199

10%
11%
8%
9%
10%
15%
11%
10%
11%
7%

0.49%
0.61%
0.84
337

10%
11%
9%
11%
9%
12%
13%
9%
9%
7%

0.35%
0.56%
0.76
610

15%
15%
10%
10%
13%
9%
11%
6%
8%
3%

11%
12%
16%
13%
14%
15%
9%
6%
3%
2%

0.30%
0.39%
0.80
1203

0.20%
0.29%
0.71
5319

21%
19%
20%
17%
12%
6%
3%
1%
0%
0%

Large firms

For the stocks in each size decile, we report the percentages of stocks in the size decile that are found in each of the amortized spread deciles defined in
Table 1. In addition, mean amortized spreads, effective spreads, share turnover and market value (in millions) are reported for each size decile. A stocks
amortized spread is the product of the effective spread and the number of shares traded summed over all trades and expressed as an annual percent of
equity value.

Table 5
Market value of equity and the amortized spread

178
J.M.R. Chalmers, G.B. Kadlec/Journal of Financial Economics 48 (1998) 159188

12%
11%
14%
14%
5%
7%
10%
6%
7%
12%

0.48%
0.86%
0.71
0.22

Decile mean:
Amortized spread
Effective spread
Turnover
Book-to-market
0.42%
0.79%
0.66
0.39

12%
12%
10%
8%
12%
11%
11%
8%
10%
7%

Low B/M 2

Book-to-market decile

Low
2
3
4
5
6
7
8
9
High

Amortized spread decile

0.51%
0.81%
0.67
0.50

12%
9%
10%
10%
14%
8%
7%
10%
9%
10%

0.46%
0.88%
0.66
0.61

13%
10%
10%
8%
10%
10%
8%
8%
12%
10%

0.44%
0.92%
0.62
0.70

10%
14%
11%
15%
9%
10%
8%
8%
8%
7%

0.48%
1.02%
0.59
0.82

10%
8%
16%
10%
8%
11%
9%
6%
11%
11%

0.46%
1.03%
0.54
0.90

13%
11%
9%
8%
10%
12%
10%
11%
8%
8%

0.54%
1.25%
0.55
1.06

10%
8%
6%
11%
13%
10%
11%
13%
14%
6%

0.54%
1.14%
0.60
1.29

5%
9%
8%
9%
12%
10%
10%
13%
10%
14%

0.63%
1.63%
0.55
2.18

4%
9%
4%
7%
7%
10%
16%
16%
11%
16%

High B/M

For the stocks in each book-to-market decile, we report the percentage of those stocks that are found in each of the amortized spread deciles defined in
Table 1. In addition, mean amortized spreads, effective spreads, share turnover and book-to-market are reported for each book-to-market decile.
Observations for which B/M is negative are not included in the sample used to construct this table. A stocks amortized spread is the product of the
effective spread and the number of shares traded summed over all trades and expressed as an annual percent of equity value.

Table 6
Book-to-market and the amortized spread

J.M.R. Chalmers, G.B. Kadlec/Journal of Financial Economics 48 (1998) 159188

179

180

J.M.R. Chalmers, G.B. Kadlec/Journal of Financial Economics 48 (1998) 159188

the previous years book value of equity to market value of equity if B/M is
positive, and zero if B/M is negative, p
is the standard deviation of monthly
j,t~1
returns estimated with three to five years of data, as available, prior to the test
year, and C
measures expected transaction costs with either the expected
j,t~1
effective spread or the expected amortized spread of security j. Returns are
measured from July 1 to June 30 of the following year. We use annual returns
rather than monthly returns in an attempt to sidestep the statistical problems
that arise from the seasonality and measurement biases found in stock returns
during the month of January. For example, Bhardwaj and Brooks (1992) and
Huson (1995) find that bidask bounce causes the relations between stock
returns and market value of equity and stock returns and bidask spread to be
overstated during the month of January. Details concerning the estimation of
the independent variables in the above cross-sectional regressions are discussed
in the appendix.
Table 7 reports coefficient estimates from cross-sectional regressions of stock
returns on beta, market value of equity, book-to-market, standard deviation of
return and our two alternative measures of transaction costs. Before discussing
the results we raise two caveats. First, given data availability constraints (ISSM
data is available only from 1983 to 1992), we are able to conduct our asset
pricing tests using only nine years of data. Prior empirical studies which
examine the relation between stock returns and bidask spread related transaction costs utilize 20 or more years of data. However, these studies use year-end
closing bidask quotes as a proxy for costs incurred from the bidask spread. To
our knowledge, this study is the first to test the relation between stock returns
and the effective spread as opposed to the quoted spread.
Second, from Table 1 we know that the cross-sectional variation in amortized
spreads for Amex/NYSE stocks is relatively small. The variation in our estimates of expected amortized spreads is even smaller. For example, while the
interdecile range of amortized spreads is 1.7% (Table 1), the interdecile range of
our estimates of expected amortized spreads is 1%. Thus, it is possible that the
amortized cost of transacting is important, yet the variation in amortized
spreads for our sample stocks is not great enough to allow detection. One way to
address this issue would be to conduct our asset pricing tests using securities
with greater variation in amortized spreads, say NASDAQ stocks. Unfortunately, reported volume for NASDAQ stocks is highly inflated due to interdealer
trading and there is no systematic way to correct for differences in the overstatement across stocks (see Atkins and Dyl, 1997b).
We begin with the cross-sectional relation between stock returns and amortized spreads. From panel A of Table 7, we find weak support for a crosssectional relation between stock returns and amortized spreads. In particular,
the time-series average coefficient of the amortized spread is positive with
two-tailed p-values ranging from 0.02 to 0.18 for the alternative regression
specifications. Furthermore, the coefficient of the amortized spread is insensitive

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181

Table 7
The relation between stock returns and amortized spreads
Asset pricing tests are conducted in the spirit of Fama and MacBeth (1973). Using OLS, we estimate
the cross-sectional relation between each stocks annual return in excess of the one-year treasury
yield and b, the log of the market value of equity, the book-to-market ratio in year t!1, the
standard deviation of monthly returns, and, in panel A, the amortized spread, and, in panel B, the
effective spread. Annual returns are measured from July 1 of each year through June 30 of the
following year. Betas are estimated using a two-stage procedure similar to Kothari et al. (1995).
Market value of equity is estimated immediately prior to each test year. Standard deviation of return
is the standard deviation of monthly returns estimated with three to five years of data, as available,
prior to the test year. A stocks spread is the average effective spread over the preceding twelve
months. Amortized spreads are estimated as the product of the effective spread estimate and the
average level of share turnover for each firm over the stocks entire sample period. Panels A and
B contain time-series averages of the nine cross-sectional regression coefficients. Standard errors are
presented in parentheses. p-values for a two-tailed t-test are provided in square brackets.
Panel A: Returns and amortized spreads
r "c #c b #c ME
#c (B/M)
#c p
#c Amortized Spread
#e
j,t
0,t
1,t j
2,t
j,t~1 3,t
j,t~1 4,t j,t~1 5,t
j,t~1 j,t
Dependent variable: Return in excess of 1 year t-bill yield for firm j
Intercept

Mean coefficient
(std err)
[p-value]
Mean coefficient
(std err)
[p-value]
Mean coefficient
(std err)
[p-value]
Mean coefficient
(std err)
[p-value]

b
j

0.13
(0.04)
[0.01]
!0.03
(0.12)
[0.78]
!0.07
(0.10)
[0.54]
0.20
(0.13)
[0.16]

!0.08
(0.02)
[0.00]
!0.07
(0.01)
[0.00]
!0.07
(0.01)
[0.00]
!0.02
(0.02)
[0.42]

ME
j,t~1

0.01
(0.01)
[0.19]
0.01
(0.01)
[0.11]
0.00
(0.01)
[0.99]

(B/M)
p
j,t~1 j,t~1

0.01
(0.02)
[0.45]
0.00
(0.02)
[0.79]

!1.35
(0.48)
[0.02]

Amortized
Spread
i,t~1
4.12
(2.82)
[0.18]
4.62
(2.58)
[0.11]
4.54
(2.58)
[0.12]
7.89
(2.87)
[0.02]

Panel B: Returns and effective spreads

r "c #c b #c ME
#c (B/M)
#c p
#c EffectiveSpread
#e
j,t
0,t
1,t j
2,t
j,t~1
3,t
j,t~1
4,t j,t~1
5,t
j,t~1
j,t
Dependent variable: Return in excess of 1 year t-bill yield for firm j
Intercept

Mean coefficient
(std err)
[p-value]

0.12
(0.04)
[0.01]

b
j
!0.07
(0.02)
[0.01]

ME
j,t~1

(B/M)
p
j,t~1 j,t~1

Effective
Spread
i,t~1
0.43
(2.12)
[0.84]

182

J.M.R. Chalmers, G.B. Kadlec/Journal of Financial Economics 48 (1998) 159188

Table 7 (Continued)
Panel B: Returns and effective spreads
r "c #c b #c ME
#c (B/M)
#c p
#c Effective Spread
#e
j,t
0,t
1,t j
2,t
j,t~1
3,t
j,t~1
4,t j,t~1
5,t
j,t~1
j,t
Dependent variable: Return in excess of 1 year t-bill yield for firm j

Mean coefficient
(std err)
[p-value]
Mean coefficient
(std err)
[p-value]
Mean coefficient
(std err)
[p-value]

Intercept

b
j

ME
j,t~1

!0.12
(0.14)
[0.43]
!0.15
(0.14)
[0.33]
0.05
(0.15)
[0.73]

!0.06
(0.02)
[0.01]
!0.06
(0.02)
[0.00]
!0.00
(0.02)
[0.81]

0.02
(0.01)
[0.11]
0.02
(0.01)
[0.08]
0.01
(0.01)
[0.32]

(B/M)
p
j,t~1 j,t~1

0.01
(0.02)
[0.42]
0.00
(0.02)
[0.77]

!1.37
(0.36)
[0.00]

Effective
Spread
i,t~1
2.04
(2.77)
[0.48]
1.91
(2.76)
[0.51]
3.64
(2.64)
[0.20]

to the inclusion of either market value of equity or book-to-market. For

example, the time-series average coefficient of the amortized spread is 4.1
(t-statistic 1.49) when accompanied by beta, 4.6 (t-statistic 1.79) when accompanied by beta and market value of equity, and 4.5 (t-statistic 1.76) when
accompanied by beta, market value of equity, and book-to-market. These
results suggest that the amortized spread effect is distinct from either the size
effect or book-to-market effect. While we focus on the coefficients estimates for
the amortized spread, it is important to note that the unusual negative coefficient on beta and positive coefficient on size are consistent with the results in
Eleswarapu and Reinganum (1993) over a similar time period.
Panel B of Table 7 reports coefficient estimates from regressions of stock
returns on beta, market value of equity, book-to-market, standard deviation of
return, and effective spreads. We find no support for a cross-sectional relation
between stock returns and effective spreads. In particular, while the time-series
average coefficient of the effective spread is positive, two-tailed p-values range
from 0.20 to 0.84 in the alternative regression specifications.
The results of panel B differ from those of Amihud and Mendelson (1986),
who find a positive and significant relation between stock returns and bidask
spreads. There are a number of possible reasons for this finding. First, Amihud
and Mendelson use quoted bidask spreads to proxy for transaction costs while
we use effective spreads. Second, Amihud and Mendelson use monthly returns
data while we use annual returns data. Finally, Amihud and Mendelson use
a pooled cross-sectional time series approach, as opposed to the cross-sectional
approach of Fama and MacBeth (1973), and conduct their tests over a different
time period (19611980). The results of panel B are, however, consistent with

J.M.R. Chalmers, G.B. Kadlec/Journal of Financial Economics 48 (1998) 159188

183

those of Eleswarapu and Reinganum (1993), who use the Fama and MacBeth
(1973) methodology over a similar time period.
The strong contemporaneous association between the amortized spread and
return volatility observed in Table 3 raises the question of whether return volatility is a viable proxy for the amortized spread. Prior studies find a weak and
inconsistent cross-sectional relation between stock returns and historical standard
deviation of returns (i.e., Fama and MacBeth, 1973). Nevertheless, it is interesting
to examine whether the inclusion of standard deviation of returns in the regression
of Eq. (3) has any impact on the coefficient of the amortized spread. If, in fact,
standard deviation of returns is a viable proxy for the amortized spread, one
would expect to observe a positive coefficient for the standard deviation of returns
and, because of their high correlation, a less significant coefficient for the amortized spread. We estimate Eq. (3) with the addition of each stocks standard
deviation of monthly returns estimated over three to five years preceding each test
year, as available. Surprisingly, the coefficient for standard deviation of returns is
negative, !1.35, and significant (t-statistic !2.81, p-value(0.05), while the
coefficient for the amortized spread is now larger (7.9) and significant (t-statistic
2.75, p-value(0.05). The negative coefficient estimate for return volatility appears to be related to the negative risk premium over this period. In particular, the
coefficient estimate for beta is insignificant with the inclusion of standard deviation of return in the regression. Coefficient estimates for market value of equity
and book-to-market in this regression are insignificantly different from zero.
Thus, it appears that, if there is a relation between stock returns and standard
deviation of returns, it is distinct from that of the amortized spread. However, as
with all of our asset pricing results, we interpret these with caution due to the
limited and unique period over which the tests are conducted.
Finally, because data on quoted spreads are more readily available than data
on effective spreads, we repeat the regressions from panel A of Table 7 using
quoted spreads to calculate amortized spreads. The coefficient estimates for the
amortized quoted spread are similar to those for the amortized effective spread
reported in panel A. For example, the time-series average coefficient of the
amortized quoted spread is positive (3.1; t-statistic 1.37) when accompanied by
beta, market value of equity, and book-to-market. The coefficient estimates for
the unamortized quoted spread are similar to those for the unamortized effective
spread reported in panel B. For example, the time-series average coefficient of
the quoted spread is 0.94 (t-statistic"0.36) when accompanied by beta, market
value of equity, and book-to-market.9 These results do, however, suggest that
the effective spread conveys more information than the quoted spread.
9 As a practical matter, it is important to note that neither the amortized effective spread nor the
amortized quoted spread are priced when a single end-of-period observation is used to estimate the
spread. For example, using periods from July 1 to June 30, if for each stock the amortizd spread is
calculated from a single spread observation on June 30th and multiplied by the average turnover,
this measure of the amortized spread is not significant in Fama and MacBeth-type regressions.

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J.M.R. Chalmers, G.B. Kadlec/Journal of Financial Economics 48 (1998) 159188

Although these asset pricing results are by no means conclusive, we believe

that they are consistent with the intuitive notion that transaction costs that are
impounded in asset returns are related to the amortized cost of the spread.

6. Summary and conclusions

Empirical studies of the importance of bidask spreads in asset pricing have
focused on the magnitude of the spread as opposed to its amortized cost. We
empirically examine the reliability of using the magnitude of the spread as a proxy
for the amortized cost of the spread. We find that, in contrast to the spread, the
amortized cost of the spread is quite small. Furthermore, the distinction between
spreads and amortized spreads yields new information. For example, transportation stocks have lower average spreads than stocks in basics goods, yet,
because of their higher share turnover, transportation stocks have higher average amortized spreads than stocks in basic goods. One implication of this result
is that tests of the relation between bidask spreads and security returns which
rely solely on the magnitude of the spread are misspecified. We find that
amortized spreads are positively related to return volatility, a variable which is
positively related to both the magnitude of the spread and share turnover.
Finally, consistent with theories of transaction costs and asset pricing, we find
stronger evidence that amortized spreads are priced than we find for spreads.

Appendix A. Details of the asset pricing tests

As in Fama and French (1992), our approach is to estimate betas for portfolios and then assign a portfolio beta to each stock. This allows us to use
individual stock data for market value of equity, book-to-market, effective
spread, and amortized spread in the Fama and MacBeth (1973) style asset
pricing tests.
A.1. Estimating betas
We first estimate each stocks rank-period beta over the three to five years (as
available) prior to each test year, t. A stocks rank-period beta is the sum of the
coefficients in the regression of the stocks return on the contemporaneous and
lagged return of the CRSP equally weighted index.10 We use quarterly returns
10 Fowler and Rorke (1983) show that the equally weighted sum betas of Dimson (1979) are biased
when the market retun is autocorrelated. The 1st order autocorrelation of the quarly returns of the
equally weighted Amex/NYSE CRSP index over our sample period is 0.0005 (p"0.97). Thus, we
make no attempt to correct for this bias here.

J.M.R. Chalmers, G.B. Kadlec/Journal of Financial Economics 48 (1998) 159188

185

data and include both contemporaneous and lagged market returns in an

attempt to mitigate the effects of non-synchronous trading and price-adjustment
delays on our estimates of beta. Nonsynchronous trading and price adjustment
delays induce systematic cross-temporal covariance in short-interval returns
that do not appear to be present in longer interval returns data (see Cohen et al.,
1983). The implications of this intervalling effect for asset pricing tests is well
documented (see Handa et al., 1989; Jagannathan and Wang, 1996; Kothari,
Shanken and Sloan, 1995). This issue is particularly important for the current
study as biases in beta estimates caused by nonsynchronous trading and priceadjustment delays are likely to be related to market value of equity (Handa et al.,
1989), bidask spreads (Huson, 1995), and share turnover (Denis and Kadlec,
1994). Stocks are then assigned to one of 20 portfolios on the basis of their
rank-period beta. Following Kothari et al. (1995), test-period betas are then
estimated by regressing annual equally weighted portfolio returns on the contemporaneous CRSP equally weighted Amex/NYSE index return over the
period 19801994.
As is always the case for CAPM based asset pricing tests involving factors in
addition to beta, it could be that the additional factors capture errors in a stocks
beta estimate. In this study, we took precautions to mitigate this potential
problem by employing long-interval returns data to estimate beta (Kothari
et al., 1995). Furthermore, we believe that the amortized spread is less likely to
be correlated with errors in beta estimates because the amortized spread is
positively related to both spreads and share turnover. These variables have
opposing associations with estimation errors caused by nonsynchronous trading and price-adjustment delays.
A.2. Estimating transaction costs
The primary purpose of our asset pricing tests is to compare the relative merits
of two alternative measures of spread-related transaction costs, spreads and
amortized spreads. In this section we discuss our estimation of these two proxies.
We use each stocks average effective spread in year t!1 as our estimate of its
expected effective spread in year t. We use all of the previous years data as
opposed to the most recent observation (i.e. last trading day of December) to
avoid a potential seasonal bias in our spread estimate. Clark et al. (1992) show
that there are seasonalities in the spread and that spreads during the month of
December are significantly greater than those during other months of the year.
Thus, spread estimates taken from the month of December will be upwardly
biased estimates of the spread throughout the year.
Our approach to estimating the expected amortized spread makes use of the
approximation of Eq. (2) that the amortized spread is approximately equal to
the effective spread times share turnover. We use this simplification and estimate
each stocks effective spread and expected turnover separately and then combine

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J.M.R. Chalmers, G.B. Kadlec/Journal of Financial Economics 48 (1998) 159188

them to form an estimate of the stocks expected amortized spread. As before, we

use each stocks average effective spread in year t!1 as our estimate of its
expected spread in year t. A stocks expected turnover is taken to be the stocks
average annual turnover during the sample period for that stock. Finally,
a stocks expected amortized spread for year t is taken to be the product of its
average effective spread in year t!1 and its average turnover during the sample
period. While our estimates of expected turnover include both historical and
future turnover data, we emphasize that we are not proposing a trading strategy,
but rather testing whether stock returns are related to expected trading costs.
For our purposes, the best estimate of a stocks expected turnover is the average
turnover over the available sample period as opposed to a purely historical
measure. Furthermore, it does not appear that our estimate of expected turnover
is driving the results in Table 7. In a regression of stock returns on beta, market
value of equity, book-to-market, effective spread, and the estimate of expected
turnover, we find that the coefficient on expected turnover is insignificantly
different from zero (p-value of 0.53). Thus, while it is possible that stock returns
are related to future turnover, it is unlikely that the results of Table 7 are driven
by this relation. This is not the case when estimating asset pricing factors such as
size, book-to-market, P/E ratio, and spread which are explicit functions of stock
price, and thus, directly related to future stock returns.

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