Expected Return and the Bid-Ask Spread

This paper empirically examines the relation between the expected stock return and the bid-ask spread. Using the same portfolio formation method as in Amihud and Mendelson (1986) but different test methodologies, we do not find any clear reliable relation between the CAPM risk-adjusted return and the relative bid-ask spread. Our empirical results are more consistent with the conclusions of Constantinides (1986) that transaction costs play a minor role in the determination of expected returns in security markets. Expected Return and the Bid-Ask Spread Most asset pricing models, such as Sharpe (1964), Lintner (1965), Merton (1973), Ross (1976), Rubinstein (1976), Breeden (1979) and Cox, Ingersoll and Ross (1985), are derived with the assumption of a perfect capital market. In these cases, the expected return of a financial asset is a function of risks alone. In actual trading, however, the transaction costs can be very different for different classes of financial assets and the equilibrium expected gross return can be a function of the transaction costs also. Since investors can only consume the investment income net of transaction costs, the expected gross return should be positively correlated with transaction costs. Unfortunately, there is little agreement among the researchers of how important this positive relation between the expected return and the transaction costs is. On one hand, differences in transaction costs can induce a clientele effect. For example, high transaction cost securities tend to be held for long-term investment purposes and such cost-minimization strategies on the part of investors would attenuate any positive relation between return and transaction costs. Furthermore, Constantinides (1986) argues theoretically that transaction costs can only have a second-order effect on the liquidity premium implied by the equilibrium asset returns in an intertemporal portfolio selection model. On the other hand, Amihud and Mendelson (1986) (hereafter AM) empirically find that there is an economically and statistically significant positive relation between the expected return and the relative bid-ask spread. The relative bid-ask spread is measured as the dealer’s bid-ask spread divided by the average of the bid-price and the ask-price. Since many recent studies have found a reliable relation between expected return and (functions of) price, it is obvious that we cannot unambiguously interpret the results in AM as a relation between the expected return and the relative bid-ask spread. Miller and Scholes (1982) observe a positive relation between return and the inverse of price and point out that the inverse of price may be proxying for the errors in the estimation of risk. Since firm size and relative bid-