If investors value securities according to their returns net of trading costs, then they should require a higher expected return, the higher a stock’s bid-ask spread, in order to compensate them for the higher cost of trading. Thus the higher a stock’s spread, the higher its observed return should be. The exact relation between spread and return is complicated, however, by the effects of investors’ holding periods.
A longer holding period reduces the amortized transaction cost per unit of time. Hence low-spread stocks will tend to be held in equilibrium by short-term investors. The effect of the percentage spread on observed stock returns should thus be positive, but should be moderated as the spread increases.
The evidence culled from NYSE stock returns over the 1961–80 period indicates that spread has a highly significant positive effect on stock return. Furthermore, the monthly excess return of a stock with a 1.5 per cent spread is 0.45 per cent greater than that of a stock with a 0.5 per cent spread, but the monthly excess return of a stock with a 5 per cent spread is only 0.09 per cent greater than that of a stock with a 4 per cent spread. The returns on high-spread stocks are higher, but less spread-sensitive, than the returns on low-spread stocks.