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measurement error is inversely related to the level of the stock price.
Therefore, any bias in stock returns resulting from the use of one-eighth
pricing conventions in recording stock prices is inversely related to stock
price levels.
Even though stock prices are recorded at intervals of one-eighth of a
dollar, movements in actual trading prices are not restricted to one-eighth
intervals, ' Investors can circumvent the one-eighth price movement restric-
tion by splitting their order between pricing points one-eighth of a dollar
apart. For example, if an investor negotiates a price of $2.1875 with the
market specialist in the stock, the specialist books half of the order at
$2.25 and the other half at $2.125. By shifting the order between pricing
points, the investor can buy and sell the stock as if the price movements were
continuous. However, when split orders are booked by the specialist, they are
recorded as separate transactions at each one-eighth pricing point. If the
price of the stock i s on a downward (upward) trend, the last recorded price is
the lower (higher) of the two prices from the split order.
Another source of errors in recorded stock prices is Blume and Stambaugh's
[3] bid-asked bias. These authors argue that bias in recorded returns can
result from differences in the size of the bid-asked spreads on the stocks of
small and large firms. Blume and Stambaugh introduce bid-asked bias as an
explanation of the small-firm effect found by Reinganum [21]. These authors
argue that the difference between the bid-asked spreads of small firms and
large firms may cause the returns of the small firms to be overstated. Their
analysis hinges on the role of the market specialist as the buyer (seller) of
last resort in the stock market. If stock is purchased (sold) by an investor,
one of two transactions may have occurred. Ifthe specialist has lined up a
seller (buyer) for the security at the quoted sales price, the transaction
price is the market-clearing price. On the other hand, if the specialist sold