Theoretical analysis of the bid-ask bounce and Related Phenomena

I provide a theoretical model for two empirical phenomena observed in the NYSE and Nasdaq markets. First is the bid-ask bounce recently studied by Heston, Korajczuk and Sadka (HKS, 2008) for high-frequency data. Second is a temporary liquidity squeeze observed by Madureira and Underwood (2008) in the event studies. The model I invoke to explain empirical observations of those two groups of authors, is based on Easley, Kiefer, O’Hara and Paperman (EKHP, 1996) equations for informed trading. The estimation was performed by maximizing correlations between MCMC-generated paths and empirical time series, which also maximizes the entropy. My modeling rejects the rational expectation paradigm on a short-to-medium (15 min.to 2 days) time scale. I conclude that, given statistical uncertainty, roughly half of the bidask spread can be attributed to the arrival of new economic information and the other half to microstructure friction.