The bid–ask spread is the difference between the price at which liquidity suppliers are willing to sell (ask) and the price at which they are willing to buy (bid). In the theoretical models discussed so far, the existence of the spread is due to the adverse selection costs arising with asymmetric information and to inventory costs. This article concerns the basic empirical models of market microstructure, which take another component of the bid–ask spread into account, namely order processing costs. Order processing costs are the costs associated with the handling of a transaction and are typically modelled as fixed costs per share.

We emphasize that each trade has a buyer and a seller, so the costs for one party are the trading profits for another party. It is natural to look at costs from the perspective of an impatient trader, who consumes liquidity by placing market orders and pays the bid–ask spread. Adverse selection and inventory costs depend on traders’ behaviour, type
and preferences, and on the characteristics of the trading process. By nature, inventory costs exist only in quote-driven markets, where intermediaries have the institutional obligation to supply liquidity continuously; adverse selection and order-processing costs, on the other hand, may exist in any financial market.

More realistically, Stoll (1978) and Ho and Stoll (1981, 1983) assume that the dealer is a risk-averse liquidity provider who absorbs temporary imbalances in the order flow. The dealer therefore often holds an inventory of assets that deviates from the desired portfolio position. Since he bears the risk of price fluctuations, the dealer requires compensation in terms of a bid–ask spread. Stoll (1978), Amihud and Mendelson (1980) and Ho and Stoll (1980, 1981, 1983) are the first models that formalize this idea. Biais (1993) also introduces incomplete information about the other dealers’ inventory positions.

In the following section we introduce Stoll’s modelling approach to inventory costs, which considers a one-dealer market, and then extend the model both on the supply side (by introducing a number of competitive dealers) and on the demand side (by allowing for a rational customer who trades both for risk-sharing and to speculate on his private information). The model is then further extended by assuming that liquidity suppliers and liquidity demanders both behave non-competitively and hence take the price impact of their net demand into account.

Previous article discussed a model where dealers quote bid and ask prices that deviate from the fundamental value of the asset in order to offset the adverse selection costs that arise in the case of asymmetric information. We therefore assumed risk neutrality, so that dealers would be concerned only with adverse selection costs. In real markets, however, dealers also act as mandatory liquidity suppliers and are obliged to quote prices continuously. This means they will frequently hold undesired portfolio positions that do not lie on their efficient frontier. The costs that dealers must sustain for holding undesired positions – called ‘inventory costs’ – are another determinant of the bid–ask spread. In fact, through opposite changes in the bid–ask quotations, dealers can encourage transactions by their customers that will rebalance their portfolio. Clearly, in this context, it is crucial to assume that dealers are risk-averse, since only the riskaverse are concerned about the possible losses due to future adverse price changes.

Inventory models assign an important role to market-makers who offer the opportunity to trade at all times and therefore act as immediacy providers. The initial modelling approach (Garman, 1976) to the market-makers’ control problem assumes that their objective is to avoid bankruptcy (the ‘ruin problem’), which could be caused by the uncertainty induced by the arrival of non-synchronous buy and sell orders. As O’Hara (1995) suggests, this approach is not realistic since it assumes that a dealer quotes his prices only at the beginning of the trading game, so his inventory plays no role in the decision.

There are three principal determinants of the bid–ask spread: fixed costs, adverse selection costs and inventory costs. Fixed costs are order processing costs, such as administrative costs and compensation for the market-maker’s time. Adverse selection costs stem from asymmetric information. Finally, dealers must sustain the inventory costs of holding undesired portfolios of risky assets. By nature, only risk-averse dealers will be concerned with inventory costs, so the models that include them assume that liquidity providers are risk-averse. This assumption, which complicates the algebra, can be dispensed with in models with adverse selection.

The next two articles are dedicated to models that focus on the adverse selection component of the bid–ask spread. It will also discuss inventory and fixed costs. The model presented in this chapter draws on the work of Kyle (1985), who posits a group of risk-neutral market-makers facing insiders and liquidity traders. In fact, Kyle models the strategic interaction between an insider who chooses to trade in order to maximize his profits and a group of market-makers who take the insider’s strategy into account in updating their beliefs on the future value of the asset and setting the equilibrium price. In this way, Kyle shows how information is incorporated into prices and how the latter reflect both the trading protocol where market-makers set prices and the strategic behaviour of the informed trader.

If you have done your store and Internet market searches carefully and you have not found your invention, that is an excellent start! Chances are pretty good that your product is not currently being sold. However, you still have a couple of hurdles to get over before you can breathe easily that your idea really belongs to you. According to the United States Patent and Trademark Office (USPTO), over 97% of the patents that are issued to independent inventors never make it to the marketplace! We will talk about this grim statistic in a later chapter and how you can avoid being a part of it. But, what this statistic means is that the patent database is full of patents that have never been seen on store shelves. You will need to make sure that your idea is not one of those that have been patented already.

The United States patent database is huge and complicated, and it would be foolhardy for novice inventors to believe that they could do thorough enough searches to base utility patent applications on them. But, with a little bit of instruction in how to get around on the USPTO website, anyone can do a pretty good preliminary search. What we mean by a preliminary search is this: if you go into the USPTO database and, with a limited amount of searching, you find your invention idea staring back at you; it is time to reassess your idea. Is the prior art (patent) that you just found your exact idea? If it is not, is your idea an improvement over that product? If you believe it to be your exact idea, it is probably best to set it aside and move on to your next idea before you spend any more time or any money on it. But, if you think your idea is significantly different or better, print that patent and take it to a patent agent or attorney for a legal opinion.

If you find a patent that appears to be your exact idea, be sure to read the claims section carefully to make sure that it truly is identical before you abandon your dream. Sometimes two products can be made for the exact same purpose and they can look very similar or even identical in patent drawings and still be very different in the embodiments of how they are actually made.

Once you have searched the stores in your area as thoroughly as you possibly can and have convinced yourself that your idea is not currently being offered in the local stores, it is time to get online and begin an Internet market search. There are a couple of steps to be completed in this search in order to be thorough here and it will be a bit time-consuming, but it is not difficult. You will do a key word search and a catalog search. You will start your Internet search by making a list of key words that might be used to describe your invention. You will be searching through the links to see what products similar to your invention are being offered for sale on the Internet. Even if you feel strongly that no similar products exist, you will be surprised by what a key word search will turn up. Use the most descriptive words you can think of and get as specific as possible in the description. By this, we mean get right down to the most common descriptive words for your invention. For example, if your product is a kitchen gadget, it is far too broad to simply type in, “Kitchen Gadget.” This would bring up many more links than you would want, or need, to search. If the invention is designed for peeling grapes, say so. Type in, “Grape Peeler.” Then, as you begin to click on and follow the links that this brings up, you will find more words on those pages that will help you to reach even more links and get even more specific. For example, you may find words that are specific to that type of product – i.e. rind removal – that would lead you to entirely new links to explore.

While you are making the rounds of the stores looking at the similar products, this is an opportunity for you to do some other research that will get you ahead of the game when you are ready to market your invention. Take a small pad and a pen with you and write down the name and location of the manufacturers of similar merchandise. You will find this information on all products that are offered for sale. It will be on a sticker or a hangtag or stamped somewhere on the item. These are the companies that will be your marketing targets later if you plan to license your product for royalties.

Or, they will be your competition if you plan to build a business around your invention. Either way, it will be to your advantage to know as much as you can about these companies that manufacture products similar to your invention. If your invention is something that is not specifically a retail item, such as a medical invention that would be sold through specialty outlets, you will need to track down those specific outlets and catalogs (perhaps with the help of a medical professional) in order to search in that area. However, if you have developed such an invention, chances are excellent that you are already familiar with those specialized outlets.

If your invention is in a field that is a specialized area in which the products are not found in the usual retail outlets, you may need assistance from professionals in that industry during your research or development phase. Be sure to have each person who assists you to sign a non-disclosure document for your files.

Your early market search and preliminary patent search are both types of research for which the only cost is some of your time and they are important educational phases in the development of your invention. Your first step will be to check out every store in your local area where such an item as you envision might be offered for sale. If, for example, your idea is for a new type of kitchen gadget, you will certainly want to check the kitchen specialty stores. But, you will also want to check any and every store that sells kitchen gadgets. This means that you might find yourself looking in stores such as Wal-Mart, Target, your local grocery store, the hardware store, the corner convenience store, the department stores at the mall and even the stores that specialize in unusual items, such as Brookstone or Sharper Image. You will need to be creative in thinking of all of the places where an item such as the one you envision might be offered for sale.

In many communities across the country there are local branches of the Service Corps of Retired Executives (SCORE). This organization is a completely free mentoring program that is made up of retired executives who succeeded in their careers and who are now willing to share their knowledge and expertise, absolutely free of charge, with those who are attempting to follow in their footsteps. Each SCORE office is as different as the individuals who make it up. You may find the exact person who can answer your questions, give you direction and save you from making costly mistakes. Utilize their generosity. To locate your nearest SCORE facility, go into a search engine such as Google, and type SCORE. This will bring up a number of links to guide you to your local office.

Scattered across the country are more than 900 Small Business Development Centers. These offices are usually affiliated with community colleges. The sole purpose of the SBDC is to assist small business owners. They offer many free services and classes on a variety of subjects that will maximize the chances that your small business will succeed in the marketplace. Free counseling with business consultants who will help you to set goals and even to develop your personalized business plan is available for the asking. Some Small Business Development Centers even offer business incubation for a nominal cost. Business incubation will allow you to share an office, office equipment and even secretarial assistance with other start-up companies in office space provided by the SBDC. If you are building a business around your invention, taking advantage of the business incubation services offered by the SBDC will allow you to save substantial amounts of initial cash outlay when your income is likely to be at its lowest.

Small Business Development Centers can also provide information and guidance on how to apply for and obtain Small Business Administration loans through your local bank or credit union.