A simulation analysis of the microstructure of an order driven financial market with multiple securities and portfolio choices

In this paper we propose an artificial market where multiple risky assets are exchanged. Agents are constrained by the availability of resources and trade to adjust their portfolio according to an exogenously given target portfolio. We model the trading mechanism as a continuous auction order-driven market. Agents are heterogeneous in terms of desired target portfolio allocations, but they are homogeneous in terms of trading strategies. We investigate the role played by the trading mechanism in affecting the dynamics of prices, trading volume and volatility. We show that the institutional setting of a double auction market is sufficient to generate a non-normal distribution of price changes and temporal patterns that resemble those observed in real markets. Moreover, we highlight the role played by the interaction between individual wealth constraints and the market frictions associated with a double auction system to determine the negative asymmetry of the stock returns distribution.     

BID-ASK SPREAD COMPONENTS IN AN ORDER-DRIVEN ENVIRONMENT

The purpose of this study is to extend the bid-ask spread decomposition literature into the order-driven environment. The use of electronic limit order books, combined with order-driven market making, has been increasing rapidly in recent years because of improvements in information technology and financial market deregulation. To date, reported bid-ask spread decompositions rely almost exclusively on quote-driven or hybrid systems. This study provides bid-ask spread component estimates from one of the world's largest order-driven markets, the Stock Exchange of Hong Kong. Based on a sample of over six million observations, we estimate a median adverse selection component of 33 percent and a median order processing component of 45 percent of the spread. Dollar-volume-based decile portfolios show significant cross-sectional variation for adverse selection costs but insignificant variation for order processing costs. Finally, order persistence is consistently positive for all deciles and displays a direct relation with the level of trading activity.     

Liquidity in Frictional Asset Markets

On November 14–15, 2008, the Federal Reserve Bank of Cleveland hosted a conference on “Liquidity in frictional asset markets.” In this paper, we review the literature on asset markets with trading frictions in both finance and monetary theory using a simple search‐theoretic model, and we discuss the papers presented at the conference in the context of this literature. We will show the diversity of topics covered in this literature, for example, the dynamics of housing and credit markets, the functioning of payment systems, optimal monetary policy and the cost of inflation, the role of banks, the effect of informational frictions on asset trading.     

Presidential Address: Friction

The sources of trading friction are studied, and simple, robust empirical measures of friction are provided. Seven distinct measures of trading friction are computed from transactions data for 1,706 NYSE/AMSE stocks and 2,184 Nasdaq stocks. The measures provide insights into the magnitude of trading costs, the importance of informational versus real frictions, and the role of market structure. The degree to which the various measures are associated with each other and with trading characteristics of stocks is examined.     

A simulation analysis of the microstructure of double auction markets

Abstract

We introduce an order-driven market model with heterogeneous agents trading via a central order matching mechanism. Traders set bids and asks and post market or limit orders according to exogenously fixed rules. We investigate how different trading strategies may affect the dynamics of price, bid-ask spreads, trading volume and volatility. We also analyse how some features of market design, such as tick size and order lifetime, affect market liquidity. The model is able to reproduce many of the complex phenomena observed in real stock markets.     

Order Imbalance and Its Impact on Market Performance: Order-driven vs. Quote-driven Markets

Abstract:  The behavior of order imbalance and its impact on market performance at the two Taiwan stock index futures markets, the TAIFEX and the SGX-DT, is investigated. The TAIFEX is an order-driven call market, while the SGX-DT uses a quote-driven continuous trading system. Our empirical results show that for the TAIFEX order-driven market, the spread is minimized when order imbalance is high. In contrast, for the SGX-DT quote-driven market, the spread is highest when order imbalance is high. For both markets, order imbalance has an impact on market liquidity and volatility. The impact is larger and more significant for SGX-DT futures. This suggests that the order-driven market mechanism of TAIFEX futures is superior in absorbing order imbalance and in reducing the resulting price impact.     

Global market inefficiencies

Using point-in-time accounting data, we estimate monthly fair values of 25,000+ stocks from 36 countries. A trading strategy based on deviations from fair value earns significant risk-adjusted returns (“alpha”) in most regions, especially Asia-Pacific, that are unrelated to known anomalies. The strategy's 40–70 basis point per month alpha difference between emerging and developed markets contrast with prior research findings. A country's pre-transaction cost alpha is positively related to its trading costs, but exceeds country-specific institutional trading costs. Thus, global equity markets are inefficient, particularly in countries with quantifiable market frictions, like trading costs, that deter arbitrageurs.     

市场摩擦对特质风险溢价的影响效应——基于A股主板市场的实证分析

与国外发达市场相比,我国A股主板市场的市场摩擦因素对市场微观结构和资产定价的影响更大。在防范和化解系统性风险的过程中,进一步分析市场摩擦如何作用于特质风险定价效应的问题具有重要的理论和现实意义。本文通过采用多维市场摩擦指标来代理信息不对称、交易成本、买卖限制、卖空限制、风险对冲和外部冲击,检验中国股市特质风险和预期收益率的关系,并判断出市场摩擦因素间的差异性影响机制。回归发现,市场摩擦和特质风险因子(特质波动率和特质偏度)都具有定价效应。各维度市场摩擦因素降低了股票流动性,进而增强了特质波动率的负向定价效应,部分解释了“特质波动率之谜”,但市场摩擦对特质偏度因子溢价的影响较为微弱。同时,基于特质波动率和特质偏度因子的投资策略能够产生超越CAPM、三因子和五因子模型的绝对收益,并印证了市场摩擦对特质风险因子绝对收益的影响作用。     

Informational Frictions and Commodity Markets

This paper develops a model with a tractable log‐linear equilibrium to analyze the effects of informational frictions in commodity markets. By aggregating dispersed information about the strength of the global economy among goods producers whose production has complementarity, commodity prices serve as price signals to guide producers' production decisions and commodity demand. Our model highlights important feedback effects of informational noise originating from supply shocks and futures market trading on commodity demand and spot prices. Our analysis illustrates the weakness common in empirical studies on commodity markets of assuming that different types of shocks are publicly observable to market participants.     

With or without you: market quality of floor trading when screen trading closes early

Most stock markets are characterized by a number of parallel operating trading systems which interact intensively with each other. Usually, smaller trading platforms take the leading domestic main market as a benchmark in the price discovery process and for closing open trading positions. But what happens if the smaller trading systems suddenly have to act without this benchmark platform? We examine the effects of the reduction of the daily business hours of a screen based main trading system while a parallel floor based trading system keeps on operating. We provide evidence that liquidity improves while informed trading and informational efficiency of prices decrease at the floor based trading system as a result of the no longer operating main market. While prior research on parallel trading focuses on changes due to a growing number of trading venues, we present the first evidence on market effects when the main trading platform reduces trading hours.     

Empirical Identification of Non-Informational Trades Using Trading Volume Data

This paper empirically identifies non-informational and informational trades using stock returns and trading volume data of the U.S., Japanese, and U.K. stock markets and five individual firms. We achieve the identification by imposing a restriction from theoretical considerations. Our results show that trading volume is mainly driven by non-informational trades, while stock price movements are primarily driven by informational trades. We also find that, around the 1987 stock market crash, trading volumes due to non-informational trades increased dramatically, while the decline in stock market prices was due mainly to informational trades. Increases in volatilities both in returns and in trading volumes during and after the crash are mainly due to non-informational trades. Regarding the trading volume-serial correlation in the stock returns relationship, we find evidence that is consistent with theoretical predictions that non-informational components can account for high trading volume accompanied by a low serial correlation of stock returns.     

Centralised order books versus hybrid order books: A paired comparison of trading costs on NSC (Euronext Paris) and SETS (London Stock Exchange)

This article compares the cost of trading large capitalisation equities on the hybrid order-driven segment of the London Stock Exchange and the centralised electronic order book of Euronext. Using samples of stocks matched according to economic sector, free float capitalisation, and trading volume, our study shows that transaction costs are lower on the centralised order book than on the hybrid order book. The presence of dealers outside the electronic order book favours the frequency of large trades, but is associated with higher execution costs for all other trades and higher adverse selection and inventory costs inside the order book.     

Transparency and Liquidity: A Comparison of Auction and Dealer Markets with Informed Trading

Trading systems differ in their degree of transparency, here defined as the extent to which market makers can observe the size and direction of the current order flow. We investigate whether greater transparency enhances market liquidity by reducing the opportunities for taking advantage of uninformed participants. We compare the price formation process in several stylized trading systems with different degrees of transparency: various types of auction markets and a stylized dealer market. We find that greater transparency generates lower trading costs for uninformed traders on average, although not necessarily for every size of trade.     

Credit Availability and Asset Pricing Dynamics in Illiquid Markets: Evidence from Commercial Real Estate Markets

This article examines credit frictions and asset pricing in public and private markets with varying liquidity. We find that a tightening in credit availability is negatively related to subsequent price movements in private and public commercial real estate markets. Assets trading in illiquid segments of these markets are also susceptible to a feedback effect whereby changes in asset prices predict subsequent changes in credit availability. Controlling for investor demand, our findings suggest credit constraints play an economically significant asset pricing role in markets that are both highly levered and relatively illiquid.     

The Effect of Tick Size on Price Clustering and Trading Volume

Proposals have been made for some stock exchanges to reduce the size of their trading tick in order to lower transactions costs and, as a result, attract more trading volume and firm listings. We investigate the impact of tick size on price clustering and trading volume when the minimum price change varies with price level. Controlling the firm specific variables, we find that a smaller trading tick tends to exacerbate price clustering. Furthermore, a reduction in tick size is more likely to increase trading volume if the shares are heavily traded. These results suggest that previous studies on other stock markets may have overstated the benefits of a smaller trading tick to traders.     

Inflation dynamics with search frictions: A structural econometric analysis

The New Keynesian Phillips curve explains inflation dynamics as being driven by current and expected future real marginal costs. In competitive labor markets, the labor share can serve as a proxy for the latter. In this paper, we study the role of real marginal cost components implied by search frictions in the labor market. We construct a measure of real marginal costs by using newly available labor market data on worker finding rates. Over the business cycle, the measure is highly correlated with the labor share. Estimates of the Phillips curve using generalized method of moments reveal that the marginal cost measure remains significant, and that inflation dynamics are mainly driven by the forward-looking component. Bayesian estimation of the full New Keynesian model with search frictions helps us disentangle which shocks are driving the economy to generate the observed unit labor cost dynamics. We find that mark-up shocks are the dominant force in labor market fluctuations.     

Liquidity Provision of Limit Order Trading in the Futures Market Under Bull and Bear Markets

Abstract:  This study investigates how limit orders affect liquidity in a purely order-driven futures market. Additionally, the possible asymmetric relationship between market depth and transitory volatility in bull and bear markets and the effect of institutional trading on liquidity provision behavior are examined as well. The empirical results demonstrate that subsequent market depth increases as transient volatility increases in bull markets. Market depth exhibits significantly positive relationship to subsequent transient volatility in bull markets. Additionally, although trading volume positively influences transient volatility in bull markets, no such relationship exists in bear markets. Liquidity provision decreases when institutional trading activity intensifies during bear markets. Thus, liquidity provision for limit orders differs between bull and bear markets.     

Are Momentum Profits Robust to Trading Costs?

We test whether momentum strategies remain profitable after considering market frictions induced by trading. Intraday data are used to estimate alternative measures of proportional and non-proportional (price impact) trading costs. The price impact models imply that abnormal returns to portfolio strategies decline with portfolio size. We calculate break-even fund sizes that lead to zero abnormal returns. In addition to equal- and value-weighted momentum strategies, we derive a liquidity-weighted strategy designed to reduce the cost of trades. Equal-weighted strategies perform the best before trading costs and the worst after trading costs. Liquidity-weighted and hybrid liquidity/value-weighted strategies have the largest break-even fund sizes: $5 billion or more (relative to December 1999 market capitalization) may be invested in these momentum strategies before the apparent profit opportunities vanish.     

Transaction costs in an illiquid order‐driven market

Transaction costs in many international equity markets are much larger than those in the USA. This raises questions such as what trade size these reported trading costs relate to and whether investors can reduce trading costs by timing their trades. We show, using data from the order‐driven New Zealand market, that transaction costs are frequently lower for larger trades, particularly in small stocks, and investors are able to reduce costs by timing their transactions. While investors who require immediate execution incur transaction costs that are much higher than reported average costs, patient investors can trade at much better rates.     

Testing for Mean-Variance Spanning with Short Sales Constraints and Transaction Costs: The Case of Emerging Markets

We propose regression-based tests for mean-variance spanning in the case where investors face market frictions such as short sales constraints and transaction costs. We test whether U.S. investors can extend their efficient set by investing in emerging markets when accounting for such frictions. For the period after the major liberalizations in the emerging markets, we find strong evidence for diversification benefits when market frictions are excluded, but this evidence disappears when investors face short sales constraints or small transaction costs. Although simulations suggest that there is a possible small-sample bias, this bias appears to be too small to affect our conclusions.