Informed Trading and Intertemporal Substitution

I examine the possibility of information-based trading in a multiperiod consumption setting. I develop a necessary and sufficient condition for trade to occur. Intertemporal substitution introduces a desire to correlate current consumption with future aggregate shocks. When agents have heterogeneous time-inseparable preferences, information differentially affects relative preferences for current and future consumption, making information-based trading mutually acceptable. The no-trade result continues to hold if there is no aggregate shock, or if agents have either homogeneous or time-separable preferences.     

FX Trading and Exchange Rate Dynamics

I examine the sources of exchange rate dynamics by focusing on the information structure of FX trading. This structure permits the existence of an equilibrium distribution of transaction prices at a point in time. I develop and estimate a model of the price distribution using data from the Deutsche mark/dollar market that prroduces two striking results:(1) Much of the short-term volatility in exchange rates comes from sampling the heterogeneous trading decisions of dealers in a distribution that, under normal market conditions, changes comparatively slowly; (2) public news is rarely the predominant source of exchange rate movements over any horizon.     

The Dynamic Properties of Financial‐Market Equilibrium with Trading Fees

We incorporate trading fees into a dynamic, multiagent general‐equilibrium model in which traders optimally decide when to trade. For that purpose, we propose an innovative algorithm that synchronizes the traders. Securities prices are not so much affected by the payment of the fees itself, but rather by the trade‐off that the traders face between smoothing consumption and smoothing holdings. In calibrated examples, the interest rate and welfare decline with trading fees, while risk premia and volatilities increase. Liquidity risk and expected liquidity are priced, leading to deviations from the consumption‐CAPM. With trading fees, capital is slow‐moving, generating slow price reversal.     

Estimating the Probability of Informed Trading

Using a new empirical model, I estimate the probability of trades being generated by privately informed traders. Inference is drawn on a trade‐by‐trade basis using data samples from the New York Stock Exchange (NYSE). The modeling setup facilitates in‐depth analysis of the estimated probability of informed trading at the intraday level and for stocks with different levels of trading activity. The most important empirical results are: (a) the intradaily pattern of the inferred probability of informed trading is highly correlated with the intradaily pattern of observed quoted spreads, (b) differences in the magnitude of quoted spreads across volume categories are not exclusively related to differences in the level of informed trading, and (c) private information is incorporated faster in the quotes for high‐volume stocks than in the quotes for low‐volume stocks.     

Volume and turn-of-the-year behavior

This paper studies the trading characteristics of listed companies by size, and year-end behavior. There were no transactions on nearly 25% of the days for the smallest decile even at the turn of year which is an active trading period for small companies. As a result of low levels of trading and the regulations governing exchange specialists, transaction prices and quotations of small listed companies may require several days to fully reflect equilibrium price changes. The data confirm the existence of a year-end seasonal pattern in rates of return for small companies and suggest that there may be a seasonal pattern for large companies as well.     

Nonfundamental Speculation Revisited

We show that a linear pure strategy equilibrium may not exist in the model of Madrigal (1996), contrary to the claim of the original paper. This is because Madrigal's characterization of a pure strategy equilibrium omits a second‐order condition. If the nonfundamental speculator's information about noise trading is sufficiently precise, a linear pure strategy equilibrium fails to exist. In parameter regions where a pure strategy equilibrium does exist, we identify a few calculation errors in Madrigal (1996) that result in misleading implications.     

Confidence and Investors' Reliance on Disciplined Trading Strategies

Researchers and practitioners in accounting and finance often investigate or advocate particular disciplined trading strategies, but little work investigates the determinants of individual investors' trading‐strategy reliance. We report two experiments, which provide evidence that the dual‐source model of overconfidence (Sniezek and Buckley [1991]) predicts the circumstances in which investors are more likely to rely on disciplined trading strategies. Our results indicate that reliance is more likely when investors trade portfolios of securities rather than trading on a case‐by‐case basis, particularly when investors have received feedback that their previous (unaided) trading decisions have been unprofitable. These results are driven by the number of shares that investors transact rather than by investors' directional agreement with the recommendations of the trading strategy, suggesting that the effects of a portfolio approach and trading experience occur by mitigating investors' overconfidence. The effects violate an aspect of economic rationality because our experiments ensure that investors in all conditions trade the same set of securities based on the same set of information.     

Informed trading and order type

Each trader must choose between a limit order, a market order, or using a floor broker. We hypothesize that informed investors will: (1) concentrate their trading in floor broker orders and (2) sometimes trade patiently. Consistent with our hypotheses, empirical results suggest that most informed trading occurs through orders executed by floor brokers and that informed floor brokers are sometimes patient. Regardless of their patience, however, quote revisions following trade executions are consistent with the hypothesis that markets recognize that floor traders are more likely to be informed than other traders. As a result, informed trading moves equilibrium security values.     

Liquidity and Autocorrelations in Individual Stock Returns

This paper documents a strong relationship between short‐run reversals and stock illiquidity, even after controlling for trading volume. The largest reversals and the potential contrarian trading strategy profits occur in high turnover, low liquidity stocks, as the price pressures caused by non‐informational demands for immediacy are accommodated. However, the contrarian trading strategy profits are smaller than the likely transactions costs. This lack of profitability and the fact that the overall findings are consistent with rational equilibrium paradigms suggest that the violation of the efficient market hypothesis due to short‐term reversals is not so egregious after all.     

Optimal consumption policies in illiquid markets

We investigate optimal consumption policies in the liquidity risk model introduced by Pham and Tankov (Math. Finance 18:613–627, 2008). Our main result is to derive smoothness C ¹ results for the value functions of the portfolio/consumption choice problem. As an important consequence, we can prove the existence of the optimal control (portfolio/consumption strategy) which we characterize both in feedback form in terms of the derivatives of the value functions and as the solution of a second-order ODE. Finally, numerical illustrations of the behavior of optimal consumption strategies between two trading dates are given.     

Derivatives traders’ reaction to mispricing in the underlying equity

This article examines trading behavior in the options market conditioned on mispricing in the underlying stock. We investigate the price equilibrium between the observed equity asset and the options-implied synthetic share as well as the relative divergence between the two prices. We find a consistently positive relation between the level of stock mispricing and violations of the upper-boundary condition using derivatives, along with an increase in price divergence. To control for the effect of shorting limitations on mispricing, we further examine prices during the short-sale ban in 2008. The results hold and in many instances are more significant during the ban period. Given the persistent disequilibria between the synthetic and observed stock prices, we argue the results are evidence of informed trading in the derivatives market.     

Insider Trading, Investment, and Liquidity: A Welfare Analysis

We compare equilibrium trading outcomes with and without participation by an informed insider, assuming inflexible ex ante aggregate investment choices by agents. Noise trading arises from aggregate uncertainty regarding other agents' intertemporal consumption preferences. The welfare levels of outsiders can thus be ascertained. The allocations without insider trading are not ex ante Pareto efficient, because our model differs from standard ones with negative exponential utility functions and normal returns. We characterize the circumstances under which the revelation of payoff-relevant information via prices—arising from insider trading—benefits outsiders with stochastic liquidity needs, by improving risk-sharing among them.     

Strategic trading, asymmetric information and heterogeneous prior beliefs

We develop a multi-period trading model in which traders face both asymmetric information and heterogeneous prior beliefs. Heterogeneity arises because traders agree to disagree on the precision of an informed trader's private signal. In equilibrium, the informed trader smooths out her trading on asymmetric information gradually over time, but concentrates her entire trading on heterogeneous beliefs toward the last few periods. As a result, the model's volume dynamics are consistent with the U-shaped intraday pattern at the close. Furthermore, the model predicts a positive autocorrelation in trading volume, and a positive correlation between trading volume and contemporaneous price volatility.     

General equilibrium pricing of options on the market portfolio with discontinuous returns

When the price process for a long-lived asset is of a mixedjump-diffusion type, pricing of options on that asset by arbitrageis not possible if trading is allowed only in the underlyingasset and a risk-less bond. Using a general equilibrium framework,we derive and analyse option prices when the underlying assetis the market portfolio with discontinuous returns. The premiumfor the risk of jumps and the diffusions risk forms a significantpart of the prices of the options. In this economy, an attemptedreplication of call and put options by the Black-Scholes typeof trading strategies may require substantial infusion of fundswhen jumps occur. We study the cost and risk implications ofsuch dynamic hedging plans.     

Did crisis alter trading of two major oil futures markets?

The paper analyzes how traders in two major oil futures markets: New York Mercantile Exchange (NYMEX) and Intercontinental Exchange, reacted to the 2008 financial crisis, particularly whether they shifted their trading pattern and whether the relative information role of the two markets changed. Using trade-by-trade data, the paper analyzes several trading characteristics including trading volume, trade size, volatility, bid–ask spread, and relative information share. On average, NYMEX is characterized by greater volume, trade size and slightly greater spread. Before the crisis, NYMEX leads the process of price discovery, and volatility and trade size are significant factors explaining this leadership. However, following the financial crisis of 2008, the leadership role of NYMEX declines and trade size and volatility are no longer significant factors. Contrary to results of most equity market research, bid–ask spread is not a significant factor in information share and causality tests indicate that causality runs from spread to information share before the crisis but the opposite holds during the crisis period.     

Basket trading under co-integration with the logistic mixture autoregressive model

In this paper, we propose a co-integration model with a logistic mixture auto-regressive equilibrium error (co-integrated LMAR), in which the equilibrium relationship among cumulative returns of different financial assets is modelled by a logistic mixture autoregressive time series model. The traditional autoregression (AR) based unit root test (ADF test), used in testing co-integration, cannot give a sound explanation when a time series passes the ADF test. However, its largest root in the AR polynomial is extremely close to, but less than, one, which is most likely the result of a mixture of random-walk and mean-reverting processes in the time series data. With this background, we put an LMAR model into the co-integration framework to identify baskets that have a large spread but are still well co-integrated. A sufficient condition for the stationarity of the LMAR model is given and proved using a Markovian approach. A two-step estimating procedure, combining least-squares estimation and the Expectation-Maximization (EM) algorithm, is given. The Bayesian information criterion (BIC) is used in model selection. The co-integrated LMAR model is applied to basket trading, which is a widely used tool for arbitrage. We use simulation to assess the model in basket trading strategies with the statistical arbitrage feature in equity markets. Data from several sectors of the Hong Kong Hang Seng Index are used in a simulation study on basket trading. Empirical results show that a portfolio using the co-integrated LMAR model has a higher return than portfolios selected by traditional methods. Although the volatility in the return increases, the Sharpe ratio also increases in most cases. This risk–return profile can be explained by the shorter converging period in the co-integrated LMAR model and the larger volatility in the ‘mean-reverting’ regime.     

Income Redistribution,Consumer Credit,and Keeping Up with the Riches

In this study, we set up a dynamic stochastic general equilibrium (DSGE) model with upward looking consumption comparison and show that consumption externalities are an important driver of consumer credit dynamics. Our model economy is populated by two different household types. Investors, who hold the economy's capital stock, own the firms and supply credit, and workers, who supply labor and demand credit to finance consumption. Furthermore, workers condition their consumption choice on the investors' level of consumption. We estimate the model and find a significant keeping up mechanism by matching business cycle statistics. In reproducing credit moments, our proposed model significantly outperforms a model version in which we abstract from consumption externalities.     

Intra Day Bid‐Ask Spreads, Trading Volume and Volatility: Recent Empirical Evidence from the London Stock Exchange

With the benefit of very high frequency (25 million 1 minute observations) and recent data (2001) for the UK, this paper explores a number of intra day patterns of stock market behaviour. More specifically, a distinct reverse J shaped bid‐ask spread pattern is noted for SETS securities, a declining bid‐ask spread pattern for non‐SETS securities, a two hump pattern for trading volume and a U‐shaped pattern for returns volatility for all securities. In terms of complementing the existing literature, the paper shows that differences in trading systems may affect the bid‐ask spread patterns, while differences in market environments (i.e. US and UK markets) seems to affect the trading volume pattern. The paper suggests avenues for future research, in particular, the need to consider what factors are significant in determining intra day patterns for different trading systems and the need for additional cross‐market comparisons to identify how institutional factors affect the behaviour of investors on an intra day basis.     

The dynamics of quote adjustments

Liquidity providers on the NYSE make faster quote adjustments towards equilibrium spreads and depths than they do on NASDAQ. Liquidity providers in both markets make faster spread and depth adjustments for stocks with more frequent trading, greater return volatility, higher prices, smaller market capitalizations, and smaller trade sizes. We find that stocks with greater information-based trading and in more competitive trading environments exhibit faster quote adjustments. The speed of quote adjustment is faster after decimalization in both markets. These results are robust and not driven by differences in stock attributes between the two markets or time periods. Overall, our results indicate that stock attributes, market structure, and tick size exert a significant impact on the speed of quote adjustment.     

Simple Technical Trading Rules and the Stochastic Properties of Stock Returns

This paper tests two of the simplest and most popular trading rules—moving average and trading range break—by utilizing the Dow Jones Index from 1897 to 1986. Standard statistical analysis is extended through the use of bootstrap techniques. Overall, our results provide strong support for the technical strategies. The returns obtained from these strategies are not consistent with four popular null models: the random walk, the AR(1), the GARCH-M, and the Exponential GARCH. Buy signals consistently generate higher returns than sell signals, and further, the returns following buy signals are less volatile than returns following sell signals, and further, the returns following buy signals are less volatile than returns following sell signals. Moreover, returns following sell signals are negative, which is not easily explained by any of the currently existing equilibrium models.