The Volatility of Bid-Ask Spreads

This study tests whether the volatility of bid-ask spreads is positively related to expected returns. After controlling for market-risk factors, we find that the average risk-adjusted excess return for stocks in the highest spread volatility quintile is around 50 basis points per month. In a variety of multivariate tests, we find robust evidence of a return premium associated with spread volatility that is both statistically significant and economically meaningful. Our results are robust to controls for a variety of stock characteristics, different tick-size regimes, and other measures of liquidity volatility.