Liquidity and market efficiency

Short-horizon return predictability from order flows is an inverse indicator of market efficiency. We find that such predictability is diminished when bid-ask spreads are narrower, and has declined over time with the minimum tick size. Variance ratio tests suggest that prices were closer to random walk benchmarks in the more liquid decimal regime than in other ones. These findings indicate that liquidity stimulates arbitrage activity, which, in turn, enhances market efficiency. Further, as the tick size decreased, open-close/close-open return variance ratios increased, while return autocorrelations decreased. This suggests an increased incorporation of private information into prices during more liquid regimes.     

Options, short-sale constraints and market efficiency: A new perspective

This paper undertakes a new investigation of the potential for options to mitigate short-sale constraints. I find that option introduction alleviates 79% of the price adjustment efficiency disparity between short-sale constrained and unconstrained stocks in relation to negative news. No significant improvement in adjustment efficiency is found in response to positive information. These results are robust to controls for endogeneity biases associated with the option introduction selection process. Further, I find evidence that post-option improvement in efficiency is similar in relation to private and public information. This suggests that short-sale constraint effects stem, at least in part, from an irrational, optimism bias or another behavioral source as suggested theoretically by Miller (1977). Collectively, these results suggest that options act as an effective substitute to short-sales, significantly contributing to the informational efficiency of the market.     

The Nasdaq-Amex Merger, Nasdaq Reforms, and the Liquidity of Small Firms

After the Nasdaq and American Stock Exchange (AMEX) merged in 1998, officials of the new entity argued that some “smaller, harder to trade” companies on Nasdaq should switch to AMEX to improve liquidity. This recommendation is based on the traditional view among academics and practitioners alike that a substantial trading cost reduction should be realized when a company switches from the multidealer Nasdaq system to the AMEX specialist system. However, in light of the 1997 Nasdaq reforms, we reexamine the validity of these arguments using data from 1996–98 on firms that switch from the Nasdaq to the AMEX or the New York Stock Exchange. Evidence from transaction costs, volatility, and stock returns shows declining benefits to switching during the sample period. Our findings indicate that the liquidity improvement from exchange listing is limited in the wake of the Nasdaq reforms of 1997.     

Local investors,price discovery,and market efficiency

This study examines the effect of locally informed investors on market efficiency and stock prices using large power outages, which are exogenous events that constrain trading. Turnover in stocks headquartered in an outage area with 0.5% of U.S. electrical customers drops by 3–7% on the first full day of the outage, and bid–ask spreads narrow by 2.5%. Firm-specific price volatility is 2.3% lower on blackout dates. This effect is larger for smaller, lesser-known stocks and in higher income areas. Consistent with a valuation discount and higher expected returns for stocks with more informed traders, firms with a one-standard-deviation higher local trading propensity have market-to-book values that are 5% lower, Tobin's Q that is 6% lower, annualized four-factor alphas that are 1.2% higher, and average spreads that are 6.5% higher. Together, the evidence suggests that informed investors contribute disproportionately to both liquidity and price discovery, and that these contributions are reflected in valuations and expected returns.     

Stock market integration and volatility spillover: India and its major Asian counterparts

Stock market integration and volatility spillover between India and its major Asian counterparties is studied. Apart from different degrees of correlations, contemporaneous intraday return spillovers between India and its Asian counterparts are found to be positively significant and bi-directional. Hong Kong, Korea, Singapore and Thailand are found to be four Asian markets from where there is significant flow of information in India. Though most of the information gets transmitted between the markets without much delay, some amount of information still remains unsent and is found to be successfully transmitted as soon as the domestic market opens in the next day.     

Financial crisis and stock market efficiency: Empirical evidence from Asian countries

This paper empirically investigates the effects of the 1997 financial crisis on the efficiency of eight Asian stock markets, applying the rolling bicorrelation test statistics for the three sub-periods of pre-crisis, crisis, and post-crisis. On a country-by-country basis, the results demonstrate that the crisis adversely affected the efficiency of most Asian stock markets, with Hong Kong being the hardest hit, followed by the Philippines, Malaysia, Singapore, Thailand and Korea. However, most of these markets recovered in the post-crisis period in terms of improved market efficiency. Given that the evidence of nonlinear serial dependencies indicates equilibrium deviation resulted from external shocks, the present findings of higher inefficiency during the crisis are not surprising as in the chaotic financial environment at that time, investors would overreact not only to local news, but also to news originating in the other markets, especially when the news events were adverse.     

Convergence to market efficiency of top gainers

This study investigates the convergence process toward efficiency of daily top gainers. The convergence process toward efficiency is much clearer as a result of using a GARCH(1, 1) model compared to the OLS model, and exhibits a monotonic decline as the time interval increases. The relationship between volatility and order imbalances is, however, not strong enough, suggesting that market makers do have the capability to reduce price volatility. This study develops an imbalance-based trading strategy, which earns a positive profit but fails to outperform the buy-and-hold strategy (i.e., open-to-close returns). A nested causality approach, which examines the dynamic return–order imbalance relationship during the price-formation process, confirms the results.     

Decimals And Liquidity: A Study Of The Nyse

Using a carefully constructed matched sample of control (nondecimal) stocks, we isolate the effects of decimalization for a sample of NYSE‐listed common stocks trading in decimals. We find that the quoted depth as well as the quoted and effective bid‐ask spreads declined significantly following decimalization. Additionally, both the number of trades and trading volume declined significantly. Stock return volatilities display an initial increase but a decline over the longer term, probably as traders become more comfortable in their new milieu.     

News-driven return reversals: Liquidity provision ahead of earnings announcements

This study documents a six-fold increase in short-term return reversals during earnings announcements relative to non-announcement periods. Following prior research, we use reversals as a proxy for expected returns market makers demand for providing liquidity. Our findings highlight significant time-series variation in the magnitude of short-term return reversals and suggest that market makers demand higher expected returns prior to earnings announcements because of increased inventory risks that stem from holding net positions through the release of anticipated earnings news. Collectively, our findings suggest that uncertainty regarding anticipated information events elicits predictable increases in the compensation demanded for providing liquidity and that these increases significantly affect the dynamics and information content of market prices.     

Foreign exchange market efficiency under recent crises: Asia-Pacific focus

The Asia-Pacific region’s currency markets are generally efficient within-country when tested using the 30 and 31 cointegration technique whereas market efficiency fails to hold when tested using Fama’s (1984) conventional regression. Using the Pilbeam and Olmo (2011) model, we reconcile these conflicting findings. The Pilbeam and Olmo (2011) model confirms within-country market efficiency. It further confirms that free-float currency markets are more resilient than managed-float currency markets among 12 Asia-Pacific economies. From the across-country perspective, the foreign exchange markets are mostly efficient and the results show that the 1997–1998 Asian financial crisis was a more disturbing event than the 2008–2009 global financial crisis in the region.     

Stock market crashes,firm characteristics,and stock returns

A number of studies have investigated the causes and effects of stock market crashes. These studies mainly focus on the factors leading to a crash and on the volatility and co-movements of stock market indexes during and after the crash. However, how a stock market crash affects individual stocks and if stocks with different financial characteristics are affected differently in a stock market crash is an issue that has not received sufficient attention. In this paper, we study this issue by using data for eight major stock market crashes that have taken place during the December 31, 1962–December 31, 2007 period with a large sample of US firms. We use the event-study methodology and multivariate regression analysis to study the determinants of stock returns in stock market crashes.     

Speed of convergence to market efficiency for NYSE-listed foreign stocks

This paper contributes to the cross-listing literature by documenting the speed of convergence to market efficiency for foreign stocks listed on the NYSE. We find that, on average, it takes 30–60 minutes for a foreign stock to achieve market efficiency. For a comparable US stock, it takes only 10–15 minutes. The significant difference between foreign and US stocks remains robust when the speed is measured by the number of transactions rather than in calendar time. After relevant firm characteristics are controlled for, the time that it takes for foreign stocks to reach efficiency is significantly negatively related to the quality of their home country institutions. We find that one possible channel through which institutions affect the speed is through their impact on information asymmetry.     

Free Float And Market Liquidity: A Study Of Hong Kong Government Intervention

The August 1998 Hong Kong government intervention in the stock market offers a natural experiment for studying the relation between a free float and market liquidity, where a free float is the portion of listed share capital that is freely traded on the market. Our findings show that, relative to a group of control stocks, there was an increase in the price effects of trades for the 33 Hang Seng Index component stocks that were bought by the government. On the other hand, there was no clear cross‐sectional relation between the change in the price effect and the magnitude of government holdings or the decrease in the free float.     

The impact of bond rating changes on corporate bond prices: New evidence from the over-the-counter market

I study the information content of bond ratings changes using daily corporate bond data from TRACE. Abnormal bond returns over a two-day event window that includes the downgrade (upgrade) are negative (positive) and statistically significant, although the reaction to upgrades is economically small. Monthly abnormal bond returns around downgrades and upgrades are statistically significant but overstate the magnitude of the reaction relative to two-day abnormal returns. Unlike the bond market, the stock market reaction to upgrades is statistically insignificant. Evidence suggests that the differing inferences on the effect of upgrades in the two markets can be attributed to wealth transfer effects rather than relative market inefficiencies. In the cross-section, the bond market response is stronger for rating changes that appear more surprising, rating changes of lower rated firms, and upgrades that move the firm from speculative grade to investment grade.     

Arrogance can be a virtue: Overconfidence,information acquisition,and market efficiency

In behavioral finance, overconfidence has been established as a prevalent psychological bias, which can make markets less efficient by creating mispricing in the form of excess volatility and return predictability. In this paper, we develop a model in which overconfidence causes investors to overinvest in information acquisition when this information could improve market efficiency by driving prices closer to true values. We study the impact of overconfidence on mispricing and information acquisition, comparing their net effect on prices. We derive several novel implications. First, overconfidence generally improves market pricing provided the level of overconfidence is not too high. Pricing can also improve even when overconfidence is arbitrarily high, depending on the amount of private information acquired relative to publicly available information.     

Order imbalance,market returns and macroeconomic news: Evidence from the Australian interest rate futures market

The relationship between order imbalance, market returns and macroeconomic news is examined in the context of the Australian interest rate futures market. Contemporaneous order imbalance exerts a significant impact on market returns in the expected direction i.e. excess buy (sell) orders drive up (down) prices. Order imbalances are related to past market returns with market participants acting in a contrarian manner across all products following market rallies. Nine major macroeconomic announcements are identified with order imbalance, and returns, reacting to such announcements in a manner that correctly reflects the news component. Following a scheduled macroeconomic announcement there is an increase in the level of information asymmetry within the interest rate futures market, demonstrated by an increased sensitivity to order flow. Finally, the pattern of order imbalance immediately prior to scheduled announcements suggests that there is no information leakage.     

U.S. corporate bond returns: A study of market anomalies based on broad industry groups

We examine three major U.S. corporate bond market indices for calendar-based anomalies over the period 1982-2002. The analysis covers the entire corporate bond market and two broad industry classes: industrials and utilities. We find mixed support for the weekend effect in the overall bond index and the industrials index and to a lesser extent in the utilities index. We also show strong evidence of a January effect. This paper not only updates the study of corporate bond market anomalies through the period 2002 but also is the first examination based on broad industry classes.     

A tale of two prices: Liquidity and asset prices in multiple markets

This paper investigates the liquidity effect in asset pricing by studying the liquidity–premium relationship of an American depositary receipt (ADR) and its underlying share. Using the [Amihud, Yakov, 2002. Illiquidity and stock returns: cross-section and time series effects. Journal of Financial Markets 5, 31–56] measure, the turnover ratio and trading infrequency as proxies for liquidity, we show that a higher ADR premium is associated with higher ADR liquidity and lower home share liquidity, in terms of changes in these variables. We find that the liquidity effects remain strong after we control for firm size and a number of country characteristics, such as the expected change in the foreign exchange rate, the stock market performance, as well as several variables measuring the openness and transparency of the home market.     

Liquidity risk and expected corporate bond returns

This paper studies the pricing of liquidity risk in the cross section of corporate bonds for the period from January 1994 to March 2009. The average return on bonds with high sensitivities to aggregate liquidity exceeds that for bonds with low sensitivities by about 4% annually. The positive relation between expected corporate bond returns and liquidity beta is robust to the effects of default and term betas, liquidity level, and other bond characteristics, as well as to different model specifications, test methodologies, and a variety of liquidity measures. The results suggest that liquidity risk is an important determinant of expected corporate bond returns.     

Liquidity and valuation in an uncertain world

During the 2007–2009 financial crisis there was little or no trading in a variety of financial assets, even though bid and ask prices existed for many of these assets. We develop a model in which this illiquidity arises from uncertainty, and we argue that this new form of illiquidity makes bid and ask prices unsuitable as metrics for establishing “fair value” for these assets. We show how the extreme uncertainty that traders face can be characterized by incomplete preferences over portfolios, and we use Bewley's (2002) model of decision making under uncertainty to derive equilibrium quotes and the nonexistence of trading at these quotes. We then suggest alternatives for valuing assets in illiquid markets.