Estimating the Effect of Transaction Costs Using the Tick Size as a Proxy

Abstract

A method is proposed for estimating the effect of transaction costs on volatility, using the tick size as a proxy. The method involves three steps: (1) collect only the cases in which the tick size changes from one regime to another; (2) estimate the effect with and without the order book size; and (3) use local data on the tick size and volatility but instruments from international markets. The first step handles stationarity and dependence. The second step is used to infer the effect of a symmetric transaction cost as the tick size is a revenue and not a cost for liquidity providers. Regressions with and without the order book may therefore indicate the extent to which this asymmetry is likely to affect the result. The third step handles endogeneity. The method is applied to intraday data from the Norwegian Stock Exchange. The results show that both the tick size and the inferred transaction costs have no significant effect on volatility.