Speed of convergence to market efficiency: The role of ECNs

Chordia, Roll and Subrahmanyam (2005, CRS) estimate the speed of convergence to market efficiency based on short-horizon return predictability of the 150 largest NYSE firms. We extend CRS to a broad panel of NYSE stocks and are the first to examine the relation between electronic communication networks (ECNs) and the corresponding informational efficiency of prices. Overall, we confirm CRS's result that price adjustments to new information occur on average within 5–15 min for large NYSE stocks. We further show that it takes about 20 min longer for smaller firms to incorporate information into prices. Most importantly, we demonstrate that the speed of convergence to market efficiency is significantly related to the type of trading platform where orders are executed, even after controlling for relative order flows, trading costs, volatility, informational effects, trading conditions, market quality, institutional trading activity, and other firm-specific characteristics. Our findings provide direct answers and insights to issues raised in a recent SEC concept release document.     

Price Limit Performance: Evidence from the Tokyo Stock Exchange

Price limit advocates claim that price limits decrease stock price volatility, counter overreaction, and do not interfere with trading activity. Conversely, price limit critics claim that price limits cause higher volatility levels on subsequent days (volatility spillover hypothesis), prevent prices from efficiently reaching their equilibrium level (delayed price discovery hypothesis), and interfere with trading due to limitations imposed by price limits (trading interference hypothesis). Empirical research does not provide conclusive support for either positions. We examine the Tokyo Stock Exchange price limit system to test these hypotheses. Our evidence supports all three hypotheses suggesting that price limits may be ineffective.     

Intraday stock price effects of ad hoc disclosures: the German case

This paper examines intraday stock price and trading volume effects caused by ad hoc disclosures in Germany. The evidence suggests that the stock prices react within 30 min after the ad hoc disclosures. The adjustment of the trading volume needs even more time. We find no evidence for abnormal high price nor trading volume reactions in the five transactions before ad hoc disclosures. The bigger the company, which announces an ad hoc disclosure, the less severe the abnormal price effect, following the announcement, is. The higher the trading volume at the last trading day before the announcement, the higher the price and trading volume effects, after the ad hoc disclosures, are.     

Price limits in futures markets: effects on the price discovery process and volatility

Price limits are actively employed by many futures exchanges as a regulatory mechanism directed at reducing volatility and improving price discovery process. The aim of this paper is to investigate whether price limits achieve these goals without affecting market liquidity for a number of agricultural futures contracts. We employ models of changing volatility in order to show that price limits do not appear to significantly reduce market volatility. In addition, we find evidence confirming the hypothesis that price limits delay price discovery instead of facilitating it. Our results also suggest that the impact of price limits on volatility and price reversals, found in previous studies, are mainly due to the properties inherent to the futures returns, such as volatility clustering. Finally, although trading decreases significantly due to the price limits, traders do not seem to switch from the contracts affected by price limits to other maturities in order to minimize the impact of circuit breakers.     

Latency,liquidity and price discovery

The speed of trading is an important factor in modern security markets, although relatively little is known about the effect of speed on liquidity and price discovery, two important aspects of market quality. On April 23, 2007, Deutsche Boerse made an important upgrade to their trading system. With the 8.0 release of Xetra, system latency was reduced from 50 ms to 10 ms. Subsequently, both quoted and effective spreads decreased, which are mainly concentrated in small- and medium-sized stocks. This increase in liquidity is due to dramatically lower adverse selection costs that were only partially translated into higher liquidity. We interpret this as a decrease in the competition between liquidity suppliers who are able to increase their revenues by more than 90 million euros. The contribution of quotes to price discovery doubles to 90% post upgrade, indicating that prices are more efficient.     

Frequency of observation and the estimation of integrated volatility in deep and liquid financial markets

Using two newly available ultrahigh-frequency datasets, we investigate empirically how frequently one can sample certain foreign exchange and U.S. Treasury security returns without contaminating estimates of their integrated volatility with market microstructure noise. Using the standard realized volatility estimator, we find that one can sample dollar/euro returns as frequently as once every 15 to 20 s without contaminating estimates of integrated volatility; 10-year Treasury note returns may be sampled as frequently as once every 2 to 3 min on days without U.S. macroeconomic announcements, and as frequently as once every 40 s on announcement days. Using a simple realized kernel estimator, this sampling frequency can be increased to once every 2 to 5 s for dollar/euro returns and to about once every 30 to 40 s for T-note returns. These sampling frequencies, especially in the case of dollar/euro returns, are much higher than those that are generally recommended in the empirical literature on realized volatility in equity markets. The higher sampling frequencies for dollar/euro and T-note returns likely reflect the superior depth and liquidity of these markets.     

The Effectiveness of Price Limits and Stock Characteristics: Evidence from the Shanghai and Shenzhen Stock Exchanges

We examine the effectiveness of price limits on Chinese A shares and investigate the characteristics of those stocks that hit their price limits more frequently. We find that the effect of price limits is asymmetric for the A shares in upward and downward price movements and different for bullish and bearish sample periods. During a bullish period price limits effectively reduce stock volatility for downward price movements, but not for upward price movements; while during a bearish period price limits effectively reduce stock volatility for upward price movements, but not for downward price movements. Second, price limits delay efficient price discovery for upward price movements, but not for downward price movements. However, we do not find evidence to suggest that price limits harmfully interfere with the stock trading processes in the Chinese A share markets. Finally, we find that actively traded stocks hit their price limits more often and tend to hit the lower limit more frequently when overall market conditions are bearish. Stocks with high book-to-market values of equity hit their upper price limits more frequently, while stocks with a high ratio of tradable shares tend to hit their price limits less frequently.JEL Classification: G10, G14, G15     

Google Internet search activity and volatility prediction in the market for foreign currency

I study whether evolution in the number of Google Internet searches for particular keywords can predict volatility in the market for foreign currency. I find that data on Google searches for the keywords economic crisis + financial crisis and recession has incremental predictive power beyond the GARCH(1,1). These results support the mixture of distributions hypothesis in that volatility is linked to the stochastic rate at which information flows into the marketplace. These results also demonstrate the potential for Google to become a storehouse of information for financial markets.     

Do FOMC minutes matter to markets? An intraday analysis of FOMC minutes releases on individual equity volatility and returns

This paper examines the 2006 to 2007 time period to determine the extent to which the release of the Federal Reserve minutes affects equity volatility and returns for 2832 individual firms. Using intraday data, we find that equity returns are essentially unaffected by FOMC minutes releases. We do find evidence of volatility effects, in that conditional volatility is lower prior to the minutes release and higher after the minutes release on release days, relative to a “control” day one week prior to the release date. These differences manifest at the 2:00–2:05 pm interval, and generally dissipate within 15 min. Consistent with previous literature, we also find evidence of both industry-specific and firm size effects in our data. Finally, we see that volatility is higher (lower) when the minutes are released after the Federal Reserve engages in restrictive (expansionary) monetary policy. Our results are robust to a variety of different definitions of the “control” dates, as well as differing industry definitions.     

Liquidity,information, strategic trading in an electronic order book: New insights from the European carbon markets

The electronic limit order book (LOB hereafter) has rapidly become the primary way of trading European carbon assets over the 4 years of the EU ETS programme (2008–2012). In this first attempt of examining the informational content of an electronic order book, we evidence that order flow imbalances have a moderate capacity to predict short term price changes. However, we find that both LOB slope and immediacy costs help to forecast quote improvements and volatility in the next 30 min. Further, we explain why informed trading is highly influential and show that it consists in mixing order splitting strategies and posting fleeting orders once the asymmetric information is reduced (Rosu, 2009). Overall, the consolidated status of the order book mirrors a high level of market uncertainty and a low degree of informational efficiency. In this way, strategic trading can in itself explain some of order book properties, independently of the degree of traders’ sophistication and market competition.     

Market microstructure: A survey

Market microstructure studies the process by which investors’ latent demands are ultimately translated into prices and volumes. This paper reviews the theoretical, empirical and experimental literature on market microstructure relating to: (1) price formation, including the dynamic process by which prices come to impound information, (2) market structure and design, including the relation between price formation and trading protocols, (3) Transparency, the ability of market participants to observe information about the trading process, and (4) Applications to other areas of finance including asset pricing, international finance, and corporate finance.     

Predicting firms' corporate governance choices: Evidence from Korea

This paper contributes to a new literature on the factors that affect firms' corporate governance practices. We find that regulatory factors are highly important, largely because Korean rules impose special governance requirements on large firms (assets > 2 trillion won). Industry factors, firm size, and firm risk are also important. Other firm-specific factors only modestly affect governance even when they are statistically significant. This suggests that many Korean firms do not choose their governance to maximize share price. Among firm-specific factors, the most significant are size (larger firms are better governed) and firm risk (riskier firms are better governed). Long-term averages of profitability and equity finance need are significant, where short-term averages are not. This is consistent with “sticky governance”, in which firms alter their governance slowly in response to economic factors.     

ARE PRICE LIMITS EFFECTIVE? EVIDENCE FROM THE ISTANBUL STOCK EXCHANGE

There is considerable discussion about controlling volatility by imposing price limits on asset prices. We examine the effects of price limits on a stock market by testing the volatility spillover, delayed price discovery, and trading interference hypotheses in a leading emerging market, the Istanbul Stock Exchange, which has a unique market microstructure as related to price limits. Our results support the volatility spillover, delayed price discovery, and trading interference hypotheses. We also show price locks at limits provide significantly stronger evidence regarding the effects of price limits than limit moves only. Finally, price limits have a significant effect on the stock market, casting doubt on their effectiveness.     

Gaining a competitive edge through acquisitions: Evidence from the telecommunications industry

I study the announcement effects of all acquisitions in the recent telecom wave on both the acquirers and their industry competitors. I find evidence of negative rival returns (? 0.55%, t-stat = 2.47) by focusing on non-horizontal acquisitions where rivals are less susceptible to experience positive returns due to increased market power or expectation that some will become future targets themselves. I find that this effect is worse for closer rivals defined as having similar size and being in the same primary service area as the acquirer. Competitor returns are positively correlated with those of the acquirers suggesting that the negative impact experienced by competitors is driven by acquisitions in which the acquirer itself is earning negative abnormal returns. Results are broadly consistent with the Competitive Advantage Hypothesis that posits acquisitions are a means of corporate restructuring in a changing environment, awarding the acquirer a competitive edge and thereby making these acquisitions costly for their non-merging competitors.     

The importance of the volatility risk premium for volatility forecasting

In this paper, we study the role of the volatility risk premium for the forecasting performance of implied volatility. We introduce a non-parametric and parsimonious approach to adjust the model-free implied volatility for the volatility risk premium and implement this methodology using more than 20 years of options and futures data on three major energy markets. Using regression models and statistical loss functions, we find compelling evidence to suggest that the risk premium adjusted implied volatility significantly outperforms other models, including its unadjusted counterpart. Our main finding holds for different choices of volatility estimators and competing time-series models, underlying the robustness of our results.     

The Dark Side of Circuit Breakers

Market-wide circuit breakers are trading halts aimed at stabilizing the market during dramatic price declines. Using an intertemporal equilibrium model, we show that a circuit breaker significantly alters market dynamics and affects investor welfare. As the market approaches the circuit breaker, price volatility rises drastically, accelerating the chance of triggering the circuit breaker—the so-called “magnet effect,” returns exhibit increasing negative skewness, and trading activity spikes up. Our empirical analysis supports the model's predictions. Circuit breakers can affect overall welfare negatively or positively, depending on the relative significance of investors' trading motives for risk sharing versus irrational speculation.     

The effects of the method used to present a complex item on the face of a financial statement on nonprofessional investors' judgments

Our study is motivated by standard setters' (FASB, 2010; IASB, 2010a) interest in better understanding the effects of item complexity and disaggregation of financial information on users' decision processes. We examine whether the method used to present a complex item on a financial statement influences nonprofessional investors' judgments. We also examine whether disaggregation influences how different levels of item complexity are associated with judgments. Using a 2 × 2 between-subjects experiment, we manipulate variables representing presentation method (disaggregation versus aggregation) and level of item complexity (which is defined pension cost with high versus low volatility). With a sample of 114 nonprofessional investors, we find that when the complex item defined pension cost is disaggregated into its component parts and displayed in different sections of the statement of comprehensive income, nonprofessional investors acquire more information about the item and are able to more accurately understand the function of the item. This, in turn, helps the nonprofessional investors decide whether the information is useful in certain judgments. Additionally, we find that when a complex item is disaggregated, nonprofessional investors place even greater weight on their perceptions of level of item complexity in certain judgments. The results of this study are of value to managers, standard setters, and investors. For instance, results suggest that disaggregating a complex item across a financial statement can help nonprofessional investors learn how the component(s) driving a complex item relates to different economic events, improving their ability to understand and process the information in their judgments.     

SWITCHING TO A TEMPORARY CALL AUCTION IN TIMES OF HIGH UNCERTAINTY

We evaluate a stock-specific circuit breaker implemented in several European stock exchanges, which consists of a short-lived call auction triggered by intraday stock-specific price limits. It differs from U.S. trading halts in that it is short-lived and nondiscretionary, and a trading mechanism (continuous or discrete) is always going. It differs from daily price limits in that trade prices are not restricted once the limit is hit. Intraday price ranges are smaller and adjusted to the recent volatility, so that limit hits are more frequent. We contribute to the debate about circuit breakers by enlarging the span of these mechanisms studied.     

Differently motivated exchange traded fund trading activities and the volatility of the underlying index

This paper examines the correlations between two types of a market index's volatility and three trading motives of the index's exchange traded funds (ETFs). We find that ETF trading driven by belief dispersion is highly correlated with both the variance in efficient price innovations (VEPI) and the index's total volatility. Privately informed ETF trading is closely connected to the VEPI but not the total volatility, while liquidity ETF trading explains the total volatility but has little power in explaining the VEPI. Moreover, the leading ETF dominates smaller ETFs in explaining both types of volatility and often has more explanatory power than control variables.     

Time to equilibrium in exchange rates: G-10 and Eastern European economies

This paper reports different times-to-equilibrium for G-10 developed economies and the Eastern European emerging economies. By applying a novel method of value-weighted index to highly-trade-linked economies, we test the purchasing power parity to the full length of time-to-equilibrium. The times-to-equilibrium obtained are: 6 years for developed and 2 years for emerging economies. These results are consistent with the sticky price hypothesis: economies trading in highly aggregated capital goods take longer time to reach price equilibrium in the face of overshooting exchange rates: the opposite is true for primary exporters. This finding is new for these two groups, and could be compared usefully with the earlier reports of long half-life for developed countries. Also, our method of measurement establishes the actual time of the theory prediction on price-to-currency relationship. It is possible to apply this methodology to study more groups of countries.