Trading Volume and Transaction Costs in Specialist Markets

Prior work with competitive rational expectations equilibrium models indicates that there should be a positive relation between trading volume and differences in beliefs or information among traders. We show that this result is sensitive to whether and how transaction costs are modeled. In a specialist market with endogenous transaction costs we show that trading volume can be negatively related to the degree of informational asymmetry in the market. Our analysis highlights the dependence of volume on market structure, and our results suggest that the “volume effects” of corporate or macroeconomic events reflect a decrease, rather than an increase, in heterogeneity of beliefs or asymmetry of information.     

Multimarket trading and liquidity: a transaction data analysis of Canada–US interlistings

We use transaction data for Toronto Stock Exchange (TSE) listed stocks to examine the impact on trading costs of the decision to interlist on a US exchange. We measure trading costs using both ‘posted’ bid-ask spreads and ‘effective’ bid-ask spreads that measure actual transaction prices relative to standing bid-ask quotes. After controlling for price level, trade size and trading volume effects, we find that overall posted and effective spreads in the domestic (TSE) market decrease subsequent to the interlisting. However, the decrease in trading costs is concentrated in those TSE stocks that experience a significant shift of total trading volume (TSE and US) to the US exchange after listing. We interpret this result in the context of theories of multimarket trading as a competitive response by TSE market makers to the additional presence of US market makers.     

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.     

Optimal Portfolio Selection with Transaction Costs

Abstract

This paper examines the lifetime portfolio-selection problem in the presence of transaction costs. Using a discrete time approach, we develop analytical expressions for the investor's indirect utility function and also for the boundaries of the no-transactions region. The economy consists of a single risky asset and a riskless asset. Transactions in the risky asset incur proportional transaction costs. The investor has a power utility function and is assumed to maximize expected utility of end-of-period wealth. We illustrate the solution procedure in the case in which the returns on the risky asset follow a multiplicative binomial process. Our paper both complements and extends the recent work by Gennotte and Jung (1994), which used numerical approximations to tackle this problem.     

On the existence of shadow prices

For utility maximization problems under proportional transaction costs, it has been observed that the original market with transaction costs can sometimes be replaced by a frictionless shadow market that yields the same optimal strategy and utility. However, the question of whether or not this indeed holds in generality has remained elusive so far. In this paper, we present a counterexample which shows that shadow prices may fail to exist. On the other hand, we prove that short selling constraints are a sufficient condition to warrant their existence, even in very general multi-currency market models with possibly discontinuous bid–ask spreads.     

From Implicit to Explicit: The Impact of Disclosure Requirements on Hidden Transaction Costs

This paper provides evidence that disclosing corporate bond investors' transaction costs (markups) affects the size of the markups. Until recently, markups were embedded in the reported transaction price and not explicitly disclosed. Without explicit disclosure, investors can estimate their markups using executed transaction prices. However, estimating markups imposes information processing costs on investors, potentially creating information asymmetry between unsophisticated investors and bond‐market professionals. We explore changes in markups after bond‐market professionals were required to explicitly disclose the markup on certain retail trade confirmations. We find that markups decline for trades that are subject to the disclosure requirement relative to those that are not. The findings are pronounced when constraints on investors' information processing capacity limit their ability to be informed about their markups without explicit disclosure.     

PIP Transactions,Price Improvement,Informed Trades and Order Execution Quality

This study focuses on innovations in order execution processes within the context of the Boston Option Exchange (BOX). More specifically, it examines the impact of the Price Improvement Process (PIP) on options quoted, effective and realised proportional spreads. We consider the PIP as a mechanism that allows the market maker to ‘internalise’ the transaction. We show that PIP transactions are associated with wider bid/ask proportional quoted spreads than non‐PIP transactions, in spite of the temporary narrowing of the effective proportional spread during PIP. We identify informed traders by focusing on the direction of trade. Using an original data set, we show that PIP transactions follow signals in the form of buy/sell orders by informed traders. We also show that PIP is a mechanism that allows the market maker to internalise a position in the same direction as that of the informed trader. We conclude that PIP does not improve the efficiency of the market but simply allows the market maker to benefit at the expense of uninformed traders.     

A comparison of transaction costs on Xetra and on Nasdaq

Abstract

In today's financial world, providing high quality of order execution at low transaction costs is vitally important to the competitiveness of trading platforms; thus the stock market's microstructure has become a subject of fierce debate and models for computing transaction costs have been needed for quite a while. Capital market synergetics is appropriate to investigate the market microstructure's effectiveness and is implemented in the computer program KapSyn.

In this paper we compare transaction costs for small, medium-size and block-size orders on each exchange, examining different market scenarios. By investigating the peculiarities of Xetra and of Nasdaq we point out their comparative advantages: calculation results clearly show the high operating efficiency of Nasdaq's small-order execution system and Xetra's favourable execution of medium-size and block-size orders. Investors' trading decisions may benefit from taking these results into account. For policy makers and academics these findings contribute to the debate about the optimal design of a market microstructure by highlighting the areas of high performance.     

Do we need big banks? Evidence on performance,strategy and market discipline

For an international sample of banks, we construct measures of a bank’s absolute size and its systemic size defined as size relative to the national economy. We then examine how a bank’s risk and return on equity, its activity mix and funding strategy, and the extent to which it faces market discipline depend on both size measures. We show that bank returns increase with absolute size, yet decline with systemic size, while neither size measure is associated with bank risk as implicit in the Z-score. These results are consistent with the view that growing to a size that is systemic is not in the interest of bank shareholders. We also find that systemically large banks are subject to greater market discipline as evidenced by a higher sensitivity of their funding costs to risk proxies, consistent with the view that they can become too large to save. A bank’s interest costs, however, are estimated to decline with bank systemic size for all banks apart from those with very low capitalization levels. This suggests that market discipline, exercised through funding costs, does not prevent banks from attaining larger systemic size.     

Asymptotic arbitrage with small transaction costs

We give characterizations of asymptotic arbitrage of the first and second kind and of strong asymptotic arbitrage for a sequence of financial markets with small proportional transaction costs λ _n on market n, in terms of contiguity properties of sequences of equivalent probability measures induced by λ _n -consistent price systems. These results are analogous to the frictionless case; compare (Kabanov and Kramkov in Finance Stoch. 2:143–172, 1998; Klein and Schachermayer in Theory Probab. Appl. 41:927–934, 1996). Our setting is simple, each market n contains two assets. The proofs use quantitative versions of the Halmos–Savage theorem (see Klein and Schachermayer in Ann. Probab. 24:867–881, 1996) and a monotone convergence result for nonnegative local martingales. Moreover, we study examples of models which admit a strong asymptotic arbitrage without transaction costs, but with transaction costs λ _n >0 on market n; there does not exist any form of asymptotic arbitrage. In one case, (λ _n ) can even converge to 0, but not too fast.     

Heterogeneous time varying transaction costs and asset pricing in international equity markets

In this paper, we examine the time variation in transaction costs relative to excess returns, in a panel consisting of 10 international equity indices over the time period 1984–2005. This is undertaken by extending the consumption CAPM (CCAPM) model proposed by Campbell and Shiller (Rev. Financ. Stud. 1:195–228, 1988) to incorporate time varying proportional transaction costs. We rigorously address both the cross-country heterogeneity in the estimated model and endogeneity. We find strong evidence that suggests transaction costs should be included as an additional explanatory variable in the CCAPM. This leads to the conclusion that transaction costs should be included in asset pricing models as their stochastic process impacts directly on private consumption expenditure.

Empirical investigation of stock index futures market efficiency: the case of the Athens Derivatives Exchange

Pricing and trading practices in the Athens Derivatives Exchange, a newly established derivatives market, result in significant futures arbitrage profit opportunities for low-cost traders. We find that a large part of the mispricing is due to transaction costs, but additional factors, such as anticipated volatility and time to maturity, also contribute. Ex ante tests reveal significant arbitrage opportunities that could have been exploited up to 30 min after they had been identified. All different tests employed indicate that the derivatives market was inefficient during its early trading history because arbitrage opportunities persisted even after other market impact costs were taken into consideration.     

Arbitrage and Viability in Insurance Markets

Insurance markets are subject to transaction costs and constraints on portfolio holdings. Therefore, unlike the frictionless asset markets case, viability is not equivalent to absence of arbitrage possibilities. We use the concept of unbounded arbitrage to characterize viable prices on a complete and an incomplete insurance market. In the complete market, there is an insurance contract for every possible event. In the incomplete market, risk can be insured through proportional and excess of loss like insurance contracts. We show how the the structure of viable prices is affected by the portfolio constraints, the transaction costs, and the structure of marketed contracts.     

Can Relationship Banking Survive Competition?

How will banks evolve as competition increases from other banks and from the capital market? Will banks become more like capital market underwriters and offer passive transaction loans or return to their roots as relationship lending experts? These are the questions we address. Our key result is that as interbank competition increases, banks make more relationship loans, but each has lower added value for borrowers. Capital market competition reduces relationship lending (and bank lending shrinks), but each relationship loan has greater added value for borrowers. In both cases, welfare increases for some borrowers but not necessarily for all.     

Do jumps mislead the FX market?

This paper investigates the link between jumps in the exchange rate process and rumours of central bank interventions. Using the case of Japan, we analyse specifically whether jumps trigger false reports of intervention (i.e. an intervention is reported when it did not occur). Intraday jumps are extracted using a non-parametric technique recently proposed by Lee and Mykland in 2008 and by Andersen et al. in 2007, and later modified by Boudt et al. in 2011. Rumours are identified by using a unique database of Reuters and Dow Jones newswires. Our results suggest that a significant number of jumps on the YEN/USD have been falsely interpreted by the market as being the result of a central bank intervention. The paper has policy implications in terms of central bank interventions. We show that in times where the central bank is known to intervene, some investors may attach a lot of weight to central bank interventions as a source of exchange rate movement, leading to a false ‘intervention explanation’ for observed jumps.     

On option pricing in binomial market with transaction costs

Option replication is studied in a discrete-time framework with proportional transaction costs. The model represents an extension of the Cox-Ross-Rubinstein binomial option-pricing model to cover the case of proportional transaction costs for one risky asset with different interest rates on bank credit and deposit. Contingent claims are supposed to be 2-dimensional random variables. Explicit formulas for self-financing strategies are obtained for this case.Received: March 2004, Mathematics Subject Classification (2000): 62P05JEL Classification: G11, G13The authors are grateful to an anonymous referee for numerous helpful comments and to Yulia Romaniuk for final corrections. The paper was partially supported by grant NSERC 264186.     

Financial derivatives,opacity, and crash risk: Evidence from large US banks

We test how the use of financial derivatives affects banks’ informational structure and future stock performance based on a sample of large bank holding companies in the US. Using banks’ use of financial derivatives as a proxy for opacity, we find that high level use of interest rate and foreign exchange derivatives are associated with an increase in the synchronicity (R²) of stock price movements with the market index, which indicates less revelation of bank-specific information to the market. This finding is consistent with the prediction of the model developed by Wagner (2007). We document that superior corporate governance tempers these effects. Finally, we find that an increase in the opacity is significantly and positively related to an increase in banks’ future stock price crash risk.     

Why are social network transactions important? Evidence based on the concentration of key suppliers and customers in China

Based on a new institutional economy framework, this study examines the formation and economic consequences of social networks (guanxi) from the perspective of key suppliers and customers in China. Results show that commercial activities which depend on networks are determined by the institutional environment. For example, companies that have lower accumulated social capital (less trust among people) and are subject to more government invention depend more on social network transactions than on the market. In addition, this study shows that network transactions can provide benefits to firms, especially in weak institutional environments. Networks can reduce transaction costs by reducing information asymmetry, i.e., increased network dependence is associated with lower credit costs and lower advertising and sales costs. Networks can also reduce the effect of industry shocks, especially negative shocks, by creating a bonding mechanism. This study contributes to our understanding of social networks in emerging markets by providing evidence on network transactions with key suppliers and customers and their influence on firms’ accounting behavior.