Semi‐transparency,dealership market,and foreign exchange market quality

This paper examines the effects of a semi-transparency event, the introduction of the electronic trading system (EBS), on the market quality of a typical dealership market – the FX market. We find that increasing transparency leads to smaller quote disagreement among dealers and higher trading volume, but the beneficial effects are bigger for uninformed dealers than informed dealers. We also find that information efficiency improves overall in the semi-transparent system; however, informed dealers are found to quote less aggressively in the more transparent market. We conclude that semi-transparency raises market quality in general, but that it is the uninformed dealers who benefit more from this increased quality.     

Herding and the information content of trades in the Australian dollar market

This study shows that the information content of FX transactions depends on the identity of market participants. Using spot FX transactions of a major Australian bank, we find that central banks have the greatest price impact, followed by non-bank financial institutions (NBFIs) such as hedge funds and mutual funds. Trades by non-financial corporations have the least impact on dealer pricing. In the interbank market, dealers with greater private information tend to choose direct trading which has lower post-trade transparency. Indirect trading via brokers is partially revealed to the market and has little price impact. The price impact largely comes from institutions in the top quartile of the trading volume. Furthermore, NBFIs have the greatest propensity for herding, followed by interbank dealers. Non-financial corporations do not herd in their trades. Except for central banks, the differential impact of market participants can largely be explained by their propensity for herding.     

Determinants of Trading Profits: The Liquidity Provision Decision

Theories show that liquidity provision implies negative contemporaneous correlation between trades and returns. Dealers on the Taiwan Stock Exchange are granted typical dealer trading advantages without obligations to provide liquidity and, thus, are ideal to test whether these advantages lead to voluntary liquidity provision (earning bid-ask spreads) or information trading (trading in the direction of the market). We find a strong positive correlation in aggregate, implying that these unrestricted dealers prefer information trading. We also find that smaller dealers are more likely to provide liquidity and that small-cap stocks (with larger bid-ask spreads) are more profitable for liquidity provision.     

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.     

Is technical analysis profitable on a stock market which has characteristics that suggest it may be inefficient?

This paper considers the returns to technical analysis on the New Zealand stock market. The small nature, short-selling constraints, lack of analyst coverage, and loose insider trading regulation suggest that the New Zealand equity market may be less efficient than overseas markets. This raises the possibility that technical analysis is still profitable in New Zealand. Using a bootstrapping technique with common null models for stock returns and 12 popular technical trading rules, we find that the returns to technical analysis in New Zealand follow a similar pattern to those in large offshore markets. Technical analysis is no longer profitable.     

The intra-day performance of market timing strategies and trading systems based on Japanese candlesticks

Abstract

We develop market timing strategies and trading systems to test the intra-day predictive power of Japanese candlesticks at the 5-minute interval on the 30 constituents of the DJIA index. Around a third of the candlestick rules outperform the buy-and-hold strategy at the conservative Bonferroni level. After adjusting for trading costs, however, just a few rules remain profitable. When we correct for data snooping by applying the SSPA test on double-or-out market timing strategies, no single candlestick rule beats the buy-and-hold strategy after transaction costs. We also design fully automated trading systems by combining the best-performing candlestick rules. No evidence of out-performance is found after transaction costs. Although Japanese candlesticks can somewhat predict intra-day returns on large US caps, we show that such predictive power is too limited for active portfolio management to outperform the buy-and-hold strategy when luck, risk, and trading costs are correctly measured.     

HIGH‐FREQUENCY EXCHANGE‐RATE PREDICTION WITH AN ARTIFICIAL NEURAL NETWORK

This paper examines how market microstructure variables can be used to forecast foreign exchange (FX) rates at frequencies of one to several minutes. We use a unique FX dataset of global inter‐dealer electronic transactions and applied the artificial neural network (ANN) as the predicting model. The immediately preceding bid and ask prices are significant factors in these predictions, which is in keeping with market microstructure theory. These microstructure factors have not been tested in an ANN model before. High‐frequency trading strategies based on the ANN model are shown to be profitable even when transaction costs are included. Copyright © 2012 John Wiley & Sons, Ltd.     

How does the market variance risk premium vary over time? Evidence from S&P 500 variance swap investment returns

We explore whether the market variance risk premium (VRP) can be predicted. We measure VRP by distinguishing the investment horizon from the variance swap’s maturity. We extract VRP from actual S&P 500 variance swap quotes and we test four classes of predictive models. We find that the best performing model is the one that conditions on trading activity. This relation is also economically significant. Volatility trading strategies which condition on trading activity outperform popular benchmark strategies, even once we consider transaction costs. Our finding implies that broker dealers command a greater VRP to continue holding short positions in index options in the case where trading conditions deteriorate.     

The dynamics of dealer markets and trading costs

In this study we examine the temporal dynamics of dealer market share and their ramification for competition and trading costs using a large sample of NASDAQ securities. Our results show that although the total market share of the top five dealers is relatively stable over time, there is significant monthly variation in the composition of the top five dealers. We show that market share turbulence among top dealers is another form of competition that narrows bid–ask spreads, especially for stocks with less competitive market structure.     

The Making of a Dealer Market: From Entry to Equilibrium in the Trading of Nasdaq Stocks

This paper provides an analysis of the nature and evolution of a dealer market for Nasdaq stocks. Despite size differences in sample stocks, there is a surprising consistency to their trading. One dealer tends to dominate trading in a stock. Markets are concentrated and spreads are increasing in the volume and market share of the dominant dealer. Entry and exit are ubiquitous. Exiting dealers are those with very low profits and trading volume. Entering market makers fail to capture a meaningful share of trading or profits. Thus, free entry does little to improve the competitive nature of the market as entering dealers have little impact. We find, however, that for small stocks, the Nasdaq dealer market is being more competitive than the specialist market.     

Informed trading in hybrid bond markets

I study the impact of pretrade transparency on trading activity in an environment where dealers, informed and uninformed alike, can choose between an electronic limit order book (LOB) and an over-the-counter (OTC) market. By investigating bond dealers' choice in the hybrid Norwegian government bond market, I explore whether they base their trading strategy on the perceived informativeness of their trades. The results imply that bond dealers act strategically to preserve the value of their information by choosing the immediacy of the LOB when trades contain information. This suggests that OTC trades are exposed to a leakage of information to other dealers.     

The electronic trading systems and bid-ask spreads in the foreign exchange market

This paper examines the impact of electronic trading systems on the bid-ask spreads in the foreign exchange market. The paper finds: first, the EBS reduces spreads significantly; second, the EBS is more influential than the Reuters system for the currency pair DEM/USD; third, dealers with information advantage tend to quote relatively wider spreads with the new systems; fourth, geographical differences in market liquidity are reduced through the new systems, and finally, the effects occur immediately and persist in the long-term. Thus, both proposed positive and negative impacts of the electronic systems are found to be true in this paper, but our findings also suggest that positive effects dominate and the electronic systems overall increase FX market liquidity.     

On the sources of private information in FX markets

We investigate the source of information advantage in inter-dealer FX trading using data on trades and counter-party identities. In liquid dollar exchange rates, information is concentrated among dealers that trade most frequently and specialize their activity in a particular rate. In cross-rates, traders that engage in triangular arbitrage are best informed. Better-informed traders are also located on larger trading floors. In cross-rates, the ability to forecast flows explains all of the advantage of the triangular arbitrageurs. In liquid dollar rates, specialist traders can forecast both order-flow and the component of exchange rate changes that is uncorrelated with flow.     

Market liquidity and depth on two different electronic trading systems: A comparison of Bund futures trading on the APT and DTB

This paper investigates the liquidity of two different electronic trading systems – the APT system at LIFFE and the DTB system. First we describe the different characteristics of the trading systems and give potential reasons as to why they might differ in liquidity. Second we investigate empirically the liquidity provided by the two trading system. The comparison is especially interesting because the Bund Futures instruments traded are identical and the markets are open simultaneously. The intra-day data used in the study is from August 1997 to February 1998. The results show that the APT has smaller spread but the DTB is slightly deeper.     

Minimum Price Variations,Time Priority,and Quote Dynamics

We analyze price competition between dealers in a security market where the bidding process is sequential. The model provides an interpretation for the evolution of the best ask and bid prices, in between transactions. We find that convergence to the competitive ask and bid prices can take time. The speed of convergence is determined by the frequency with which dealers check their offers and by the tick size. This creates a relationship between the expected trading cost and the timing of offers posted by the dealers. We also find that a zero minimum price variation never minimizes the expected trading cost. Finally, we study the role of time priority. Journal of Economic Literature Classification Numbers: D43, G10.     

The intraday timing of rating changes

Using time stamps of Standard & Poor's rating changes, we examine the timing of rating changes in an intraday setting. Our evidence shows that although most rating changes occur during trading hours, the proportion of downgrades announced after regular trading hours is higher than that of upgrades. In addition, unexpected after-hour downgrades are associated with more negative stock returns and lower trading volume in comparison to those announced during trading hours. We also find that Standard & Poor's is more likely to announce downgrades after hours when downgrades are released on busy days with many concurrent rating announcements, when they concern financial firms, and when they are unexpected. In addition, Egan-Jones Ratings (EJR), an investor-paid credit rating agency, demonstrates a similar tendency in announcing downgrades after trading hours. This is the first study to document systematic differences in the timing of credit rating changes announced before and after the market closes. Our findings suggest that Standard & Poor's announces downgrades after trading hours to better disseminate information, and thus have important policy implications.     

Order aggressiveness and quantity: How are they determined in a limit order market?

Dealers trading in a limit order market must choose both the order aggressiveness and the quantity for their orders. Since little research has considered how dealers make this trade-off, we empirically investigate how dealers jointly make these decisions in the foreign exchange market using a unique simultaneous equations model. Our model uses an ordered probit model to account for the discrete nature of order aggressiveness and a censored regression model to capture the quantity decision recognizing the clustering of orders at the smallest available quantity, $1 million. Using two currency pairs with very different trading characteristics, we find evidence of a trade-off between order aggressiveness and quantity. We also find a significant role being played by factors related to the levels of information asymmetry and liquidity in the dealers’ choices of both the order aggressiveness and quantity.     

The efficiency of international information flow: Evidence from the ETF and CEF prices

While similar in their trading and organization, closed-end funds (CEFs) and exchange-traded funds (ETFs) differ in their liquidity and ease of arbitrage. We compare their price transmission dynamics using a sample of funds that invest in foreign securities and are most likely to show the deficiencies in the manner in which they process information. Our analysis shows that ETF returns are more closely related to their portfolio returns than are CEF returns. However, both fund types underreact to portfolio returns but overreact to domestic stock market returns. A simple trading strategy using these results is profitable with roundtrip trading costs less than 1.38% for CEFs and 0.71% for ETFs.     

Competing for Order Flow in OTC Markets

We develop a model of a two‐sided asset market in which trades are intermediated by dealers and are bilateral. Dealers compete to attract order flow by posting the terms at which they execute trades—which can include prices, quantities, and execution speed—and investors direct their orders toward dealers who offer the most attractive terms. We characterize the equilibrium in a general setting, and we illustrate theoretically and numerically how the model can account for several important trading patterns in over‐the‐counter markets, which do not emerge from existing models.     

Reputation and interdealer trading: a microstructure analysis of the Treasury Bond market

Trading generates not only information about the payoff of the assets traded, but also information about the traders themselves. Over time this information creates reputation. By using a unique dataset on the Treasury bond market, we derive a measure of reputation. This is then used to group dealers on the basis of their reputation and to analyze how they react to the reputation of other dealers. We show that the same type of trade, on the same asset, in the same market can generate different volume and volatility patterns depending on the type of dealers originating it. We also identify the “salient traders”. These traders, even if they do not originate the biggest volume of trade, have the highest impact on the market. These results have strong implications in terms of forecastability of future returns, volatility and overall trading volume because they show that most of the explanatory power of trades is due to salient traders.