A simple time-series market microstructure model is constructed within which existing models of spread components are reconciled. We show that existing models fail to decompose the spread into all its components. Two alternative extensions of the simple model are developed to identify all the components of the spread and to estimate the spread at which trades occur. The empirical results support the presence of a large order processing component and smaller, albeit significant, adverse selection and inventory components. The spread components differ significantly according to trade size and are also sensitive to assumptions about the relation between orders and trades.

To what extent are the empirical regularities implied by market microstructure theories useful in predicting the short-run behavior of stock returns? A two-equation econometric model of quote revisions and transaction returns is developed and used to identify the relative importance of different microstructure theories and to make predictions. Microstructure variables and lagged stock index futures returns have in-sample and out-of-sample predictive power based on data observed at five-minute intervals. The most striking microstructure implication of the model, confirmed by the empirical results, specifies that the expected quote return is positively related to the deviation between the transaction price and the quote midpoint while the expected transaction return is negatively related to the same variable.

The law of one price (LOP) is tested for narrowly defined commodities traded in futures markets in different countries during the period 1973–80. Although the LOP holds as an average tendency for most of the commodities, there are instances of large riskless arbitrage returns (before transactions costs). Deviations from the LOP tend to be commodity specific rather than due to a common external factor and they tend to be smaller the longer the maturity of the futures contract.

The law of one price (LOP) is tested for narrowly defined commodities traded in futures markets in different countries during the period 1973–80. Although the LOP holds as an average tendency for most of the commodities, there are instances of large riskless arbitrage returns (before transactions costs). Deviations from the LOP tend to be commodity specific rather than due to a common external factor and they tend to be smaller the longer the maturity of the futures contract.

The behavior of competing dealers in securities markets is analyzed. Securities are characterized by stochastic returns and stochastic transactions. Reservation bid and ask prices of dealers are derived under alternative assumptions about the degree to which transactions are correlated across stocks at a given time and over time in a given stock. The conditions for interdealer trading are specified, and the equilibrium distribution of dealer inventories and the equilibrium market spread are derived. Implications for the structure of securities markets are examined.

The behavior of competing dealers in securities markets is analyzed. Securities are characterized by stochastic returns and stochastic transactions. Reservation bid and ask prices of dealers are derived under alternative assumptions about the degree to which transactions are correlated across stocks at a given time and over time in a given stock. The conditions for interdealer trading are specified, and the equilibrium distribution of dealer inventories and the equilibrium market spread are derived. Implications for the structure of securities markets are examined.