Dealer spread is the price investors pay to have trades executed promptly. In order to provide prompt execution when buy and sell orders don’t match, a dealer takes positions. In doing so, he incurs certain costs. Which of these costs contribute to his market spread is still a matter of controversy.
The most controversial of these costs are those relating to risk. Like any investor, a securities dealer faces two types—systematic risk, the impact of general market conditions on the return of the individual security; and unsystematic risk, the risk due to all the other factors affecting its return. Because, according to the capital asset pricing model, the systematic risk is fully compensated for by the expected return, it should not affect the dealer’s spread.
The dealer can eliminate unsystematic risk by holding a large enough number of securities. He may, however, choose not to do this, in which case unsystematic risk becomes a primary cost of holding inventory.
Another potential cost to dealers arises from trading with insiders. If a dealer cannot distinguish those customers who have (presumably legal) inside information from those who don’t, he must increase the spreads charged to both. The authors believe insider risk is positively related to unsystematic risk because it reflects events specific to the company: The more often these events occur, the greater the unsystematic risk and the greater the insider’s opportunity to trade against the dealer advantageously.
The authors’ regression study of 314 over-the-counter companies supports the hypothesis that dealers increase their spreads when faced with increased unsystematic risk. Either the cost of diversifying is prohibitive for dealers, or unsystematic risk is a proxy for the losses they suffer when trading with insiders.