Adjusted average spread

What Is Adjusted Average Spread?

Adjusted average spread is a financial metric used within market microstructure and other areas of finance to provide a more nuanced measure of the cost of trading or the difference between related asset prices than a simple raw spread. Unlike the basic bid-ask spread, which is the immediate difference between the highest price a buyer is willing to pay and the lowest price a seller is willing to accept, an adjusted average spread incorporates additional factors. These factors can include the actual execution price of a trade, the impact of market makers' activities, or adjustments for embedded options in fixed income securities. It aims to capture the true transaction costs or a more accurate representation of market friction over a period, rather than a snapshot.

History and Origin

The concept of "spreads" as a measure of trading cost has existed as long as organized markets. However, the refinement into adjusted average spreads evolved with increasing market complexity, technological advancements, and regulatory demands for greater transparency in order execution.

A significant driver for the development and adoption of more sophisticated spread measures, such as the effective spread (often considered a form of adjusted average spread), has been regulatory oversight. For instance, the U.S. Securities and Exchange Commission (SEC) enacted Rule 605 of Regulation NMS, which mandates market centers and, more recently, larger broker-dealers to publish monthly reports detailing their execution quality. These reports include metrics like the effective spread, which offers a more realistic assessment of trading costs by considering the actual price at which an order is executed relative to the prevailing quote midpoint. The SEC modernized Rule 605 to enhance transparency for investors, expanding reporting entities and updating report content to reflect evolved equity markets.¹⁶

Similarly, in the bond market, the Financial Industry Regulatory Authority (FINRA) introduced the Trade Reporting and Compliance Engine (TRACE) in 2002. TRACE brought near real-time price dissemination to the over-the-counter bond market, which was previously opaque.¹⁵ This increased transparency allowed for better analysis of bond spreads, paving the way for more sophisticated adjusted average spread calculations in fixed income. The system requires FINRA members to report corporate debt transactions within 15 minutes of execution, enhancing market integrity and often resulting in lower trading costs for participants.¹³, ¹⁴

Key Takeaways

• Adjusted average spread provides a comprehensive measure of trading costs or yield differences, beyond simple quoted spreads.
• It often accounts for the actual execution price, market conditions, or embedded features of a financial instrument.
• Regulatory initiatives, such as SEC Rule 605 and FINRA TRACE, have propelled the adoption and standardization of various adjusted spread calculations.
• A lower adjusted average spread typically indicates greater market liquidity and more efficient trading.
• This metric is crucial for evaluating execution quality, analyzing bond performance, and understanding true transaction costs.

Formula and Calculation

The term "Adjusted Average Spread" can refer to different calculations depending on the asset and the specific adjustment being made. One common instance is the Effective Spread, which is frequently used to measure the true cost of trading an equity.

The Effective Spread is calculated as:

Where:

• Execution Price: The actual price at which a trade is completed.
• Midpoint Price: The average of the prevailing bid price and ask price at the time the order is received. It can be expressed as: $\text{Midpoint Price} = \frac{\text{Bid Price} + \text{Ask Price}}{2}$

This formula measures the difference between the execution price of a market order and the midpoint of the quoted bid-ask spread at that moment, then doubles it to represent a round-trip transaction cost.¹²

For fixed income securities with embedded options, another form of adjusted spread is the Option-Adjusted Spread (OAS). This complex calculation involves projecting future cash flows across numerous interest rate scenarios, incorporating assumptions about how the embedded option might affect these cash flows. The OAS is the constant spread that, when added to the benchmark yield curve, discounts the security's projected cash flows to its current market price.

Interpreting the Adjusted Average Spread

Interpreting an adjusted average spread requires understanding its specific context and the type of adjustment made. In general, for measures related to trading costs like the effective spread, a lower adjusted average spread is desirable. It indicates that the actual cost of executing trades is closer to the theoretical midpoint between bid and ask prices, signifying better order execution quality and higher market liquidity.

For example, if a stock consistently trades with a small effective spread, it suggests that investors are incurring minimal implicit transaction costs when their orders are filled. Conversely, a wide effective spread implies higher costs, which can significantly erode returns, especially for active traders or large institutional orders. Such wider spreads often correlate with lower trading volumes, increased market volatility, or less competition among market makers.

In the context of Option-Adjusted Spread (OAS) for fixed income securities, the interpretation is different. OAS allows investors to compare the yield premium of complex bonds (those with embedded options like callable bonds or mortgage-backed securities) against a risk-free benchmark, after accounting for the impact of these options. A higher OAS for two comparable bonds might suggest that one offers a greater risk-adjusted return relative to the benchmark, considering the potential exercise of its embedded options.

Hypothetical Example

Consider a hypothetical stock, "InnovateTech (ITEC)," trading on an exchange. At a particular moment, the bid price for ITEC is $49.90, and the ask price is $50.10. The midpoint of the quoted spread is $($49.90 + $50.10) / 2 = $50.00$. The raw bid-ask spread is $$50.10 - $49.90 = $0.20$.

Now, let's say an investor places a market order to buy 100 shares of ITEC. Due to favorable market conditions or price improvement offered by their broker, the order is executed at $50.05 per share, which is better than the quoted ask price of $50.10.

To calculate the effective spread for this transaction:

In this example, the adjusted average spread (specifically, the effective spread) for this trade is $0.10. This is lower than the quoted bid-ask spread of $0.20, reflecting the price improvement received by the investor. If the order had been executed at the full ask price of $50.10, the effective spread would have been $0.20, identical to the quoted spread. This demonstrates how an adjusted average spread like the effective spread provides a more accurate picture of the actual cost incurred by the investor.

Practical Applications

Adjusted average spreads are critical in several areas of finance, offering deeper insights into market dynamics and costs:

• Execution Quality Analysis: For institutional investors and broker-dealers, tracking adjusted average spreads, particularly effective spreads, is vital for assessing the quality of order execution. It helps them evaluate how effectively brokers are minimizing transaction costs for their clients. Regulatory bodies like the SEC use these metrics to monitor market efficiency and fairness, requiring detailed reports from market participants.¹⁰, ¹¹
• Bond Market Analysis: In the fixed income market, Option-Adjusted Spread (OAS) is a key metric for valuing and comparing complex bonds, such as mortgage-backed securities or callable corporate bonds. It helps investors understand the yield premium an investor receives for bearing risks associated with embedded options, providing a more accurate comparison than simple yield-to-maturity.
• Identifying Hidden Costs: Studies have highlighted that despite "zero-commission" trading, retail investors still incur implicit costs through the bid-ask spread. Academic research indicates that these transaction costs for simultaneous, identical market orders can vary dramatically between brokers.⁹ The adjusted average spread can help uncover these "hidden" costs, providing a more transparent view of what investors truly pay.⁷, ⁸
• Market Liquidity Assessment: Spreads are a fundamental measure of market liquidity. A tighter adjusted average spread generally signifies a highly liquid market where assets can be bought and sold quickly without significant price impact. This is crucial for portfolio managers and large traders who need to move in and out of positions efficiently.
• Financial Intermediation Evaluation: For financial intermediaries, such as market makers, the spread represents a revenue source. Analyzing adjusted average spreads helps them optimize their quoting strategies and manage inventory risk, ensuring they capture sufficient compensation for providing immediacy.

Limitations and Criticisms

While adjusted average spreads offer more comprehensive insights than simple quoted spreads, they come with certain limitations and criticisms:

• Model Dependence: Especially for metrics like the Option-Adjusted Spread (OAS), the calculation relies heavily on complex financial models and numerous assumptions about future interest rate paths and prepayment behaviors. Different models or variations in assumptions can lead to different OAS values, making comparisons challenging and introducing potential inaccuracies.⁶
• Data Intensive: Calculating accurate adjusted average spreads, particularly effective spreads, requires high-frequency trading data, including precise execution times and prevailing bid-ask spreads at the moment of order receipt. Access to such granular data can be limited for individual investors.
• Complexity and Interpretability: The calculation and interpretation of some adjusted average spreads can be complex, requiring a solid understanding of market microstructure and quantitative finance. This complexity can make it difficult for non-expert investors to fully grasp the implications of these metrics.
• Asymmetries in Spreads: Research in market microstructure suggests that effective spreads can exhibit asymmetries, meaning the cost for a buy order might differ from that of a sell order, even for the same security.⁵ This asymmetry can arise from factors like informational advantages or inventory management by market makers, complicating a uniform interpretation of the "average" cost.
• Impact of Market Volatility: During periods of high market volatility or low liquidity, spreads can widen dramatically. While adjusted spreads account for actual execution prices, the underlying market conditions can still distort the perceived "average" cost, as extreme events may skew the data.³, ⁴

Adjusted Average Spread vs. Bid-Ask Spread

The primary difference between an adjusted average spread and the standard bid-ask spread lies in their scope and the factors they consider. The bid-ask spread is the most fundamental measure of transaction cost, representing the immediate difference between the highest price a buyer is willing to pay (bid) and the lowest price a seller is willing to accept (ask) at a given moment. It is a direct reflection of supply and demand and the compensation for financial intermediation provided by market makers.¹, ²

An adjusted average spread, on the other hand, takes this basic concept and refines it. It goes beyond the static quoted spread to incorporate real-world execution complexities and other market factors over a period. For instance, the effective spread, a common type of adjusted average spread, measures the true cost by comparing the actual trade price to the midpoint of the bid-ask spread at the time the order was received. This accounts for phenomena like price improvement, where a trade executes at a price better than the prevailing quote. Other adjusted average spreads, like the Option-Adjusted Spread, apply this "adjustment" concept to different asset classes, such as bonds with embedded options, to account for their complex cash flow dynamics. While the bid-ask spread is a simple, instantaneous measure, an adjusted average spread aims to provide a more accurate and comprehensive view of trading costs or relative value over time or under specific conditions.

FAQs

What does "adjusted" mean in the context of a spread?

"Adjusted" means that the basic spread (like the bid-ask spread) has been modified to account for additional factors that influence the true cost of a transaction or the value of a security. This could include the actual execution price of a trade, the presence of embedded options in a bond, or other market dynamics.

Why is an adjusted average spread important for investors?

An adjusted average spread provides a more accurate picture of the true cost of trading or the yield premium of certain securities. For example, it helps investors understand the hidden costs of "commission-free" trading or compare the relative value of complex bonds more fairly by accounting for factors beyond simple quoted prices or yields. It's essential for evaluating order execution quality and minimizing transaction costs.

How does the effective spread relate to an adjusted average spread?

The effective spread is a widely used example of an adjusted average spread, particularly in equity markets. It measures the difference between the actual price at which a trade is executed and the midpoint of the quoted bid-ask spread, providing a more realistic assessment of what an investor truly paid for a transaction.

Is Option-Adjusted Spread (OAS) a type of adjusted average spread?

Yes, the Option-Adjusted Spread (OAS) is a type of adjusted spread specific to fixed income securities that have embedded options (e.g., callable bonds, mortgage-backed securities). It adjusts the yield spread to account for the impact of these options on the security's expected cash flows, using complex models. OAS is typically measured in basis points.

How does market liquidity affect adjusted average spreads?

Highly liquid markets generally exhibit narrower adjusted average spreads because there are many buyers and sellers, leading to competitive pricing and easier execution. Conversely, illiquid markets often have wider adjusted average spreads due to fewer participants and higher risk for market makers, resulting in higher transaction costs.