Consistency between Predicted and Actual Bid‐Ask Quote‐Revisions

This paper employs a “transaction” data‐base to study whether observed quote‐revisions are consistent with those predicted by the adverse selection and inventory cost theories of the bid‐ask spread. We find that actual quote‐revisions are consistent with the theoretical prediction in only 25% of the cases. Furthermore, quote‐revision patterns are found to be strongly dependent on the level of the outstanding spread and, to a lesser extent, on the transaction size. These systematic patterns, unrelated to the inventory cost and adverse selection theories, are consistent with the effect on quote‐revisions of the limit order book and the minimum 1/8 price‐change rule.