Are options redundant? Further evidence from currency futures markets

This paper investigates the impact of the introduction of options on the underlying asset's price formation process, using Geweke feedback measures. We derive the feedback measures from the Deutsche Mark, British Pound, Swiss Franc, Japanese Yen and Canadian Dollar futures and spot prices, before and after the introduction of options for these currency futures. While each currency market maintains some distinct characteristics in the post-option period, a common theme is found: after the option introduction, the instantaneous feedback between spot and futures markets improves drastically. The feedback from the spot to the futures market tends to decrease and remains small. The feedback from the futures market to the spot market tends to decrease as well. These results confirm the dominance of options markets, probably due to their smaller transaction costs. When made available, options assume a leading role for information transmission in currency markets.     

Price discovery in currency markets

This paper examines the price discovery process in currency markets, basing its analysis on the pivotal distinction between the customer (end-user) market and the interdealer market. It first provides evidence that this price discovery process cannot be based on adverse selection between dealers and their customers, as postulated in standard models, because the spreads dealers quote to their customers are not positively related to a trade’s likely information content. The paper then highlights three factors familiar in the literature – fixed operating costs, market power, and strategic dealing – that may explain the cross-sectional variation in customers’ spreads. The paper finishes by proposing a price discovery process relevant to liquid two-tier markets and providing preliminary evidence that this process applies to currencies.     

Stock price synchronicity and analyst coverage in emerging markets

This paper examines the relation between the stock price synchronicity and analyst activity in emerging markets. Contrary to the conventional wisdom that security analysts specialize in the production of firm-specific information, we find that securities which are covered by more analysts incorporate greater (lesser) market-wide (firm-specific) information. Using the R² statistics of the market model as a measure of synchronicity of stock price movement, we find that greater analyst coverage increases stock price synchronicity. Furthermore, after controlling for the influence of firm size on the lead–lag relation, we find that the returns of high analyst-following portfolio lead returns of low analyst-following portfolio more than vice versa. We also find that the aggregate change in the earnings forecasts in a high analyst-following portfolio affects the aggregate returns of the portfolio itself as well as those of the low analyst-following portfolio, whereas the aggregate change in the earnings forecasts of the low analyst-following portfolio have no predictive ability. Finally, when the forecast dispersion is high, the effect of analyst coverage on stock price synchronicity is reduced.     

Global private information in international equity markets

This paper studies international equity markets when some investors have private information that is valuable for trading in many countries simultaneously. We use a dynamic model of equity trading to show that global private information helps explain US investors’ trading behavior and performance. In particular, the model predicts global return chasing (positive co-movement of US investors’ net purchases with returns in many countries) which we show to be present in the data. Return chasing in our model can be due to superior performance of US investors, not inferior knowledge or naive trend-following. We also show that trades due to private information are strongly correlated across countries. A common (global) factor accounts for about half their variation.     

Explaining underpricing of IPOs in frontier markets: Evidence from the Nigeria Stock Exchange

The paper provides empirical analyses of IPO underpricing on the Nigerian Stock Exchange, from the period 1990 to 2006. The results indicate an average abnormal initial day returns of 43.1%. There is evidence of long-run underperformance of 0.6%. Results from our regression model explaining initial abnormal returns for the IPOs of Nigeria show that size of firm and audit quality are important variables affecting underpricing. The results also show the presence of a non-linear relationship between the offer price and underpricing.     

Foreign participation in local currency bond markets

Countries that cannot attract foreigners to invest in their local currency bonds run the risk of currency mismatches that can result in painful crises. We analyze foreign participation in the bond markets of over 40 countries. Bond markets in less developed countries have returns characterized by high variance and negative skewness, factors that we show are eschewed by U.S. investors. While results based on a three-moment CAPM indicate that it is diversifiable idiosyncratic risk that U.S. investors shun, our analysis suggests that countries can improve foreign participation by reducing macroeconomic instability.     

The wandering weekday effect in major stock markets

This paper reports a wandering weekday effect: the pattern of day seasonality in stock market returns is not fixed, as assumed in the Monday or weekend effects, but changes over time. Analysing daily closing prices in eleven major stock markets during 1993–2007, our results show that the wandering weekday is not conditional on average returns in the previous week (the “twist” in the Monday effect). Nor does it diminish through the period of analysis. The results have important implications for market efficiency, and help to reconcile mixed findings in previous studies, including the reported disappearance of the weekday effect in recent years.     

The impact of joint participation on liquidity in equity and syndicated bank loan markets

Market liquidity is impacted by the presence of financial intermediaries that are informed and active participants in both the equity and the syndicated bank loan markets, specifically informationally advantaged lead arrangers of syndicated bank loans that simultaneously act as equity market makers (dual market makers). Employing a two-stage procedure with instrumental variables, we identify the simultaneous equations model of liquidity and dual market maker decisions. We find that the presence of dual market makers improves the liquidity of the more competitive and transparent equity markets, but widens the spread in the less competitive over-the-counter loan market, particularly for small, informationally opaque firms.     

The impact of sovereign rating actions on bank ratings in emerging markets

This paper analyses the effects of sovereign rating actions on the credit ratings of banks in emerging markets, using a sample from three global rating agencies across 54 countries for 1999–2009. Despite widespread attention to sovereign ratings and bank ratings, no previous study has investigated the link in this manner. We find that sovereign rating upgrades (downgrades) have strong effects on bank rating upgrades (downgrades). The impact of sovereign watch status on bank rating actions is much weaker and often insignificant. The sensitivity of banks’ ratings to sovereign rating actions is affected by the countries’ economic and financial freedom and by macroeconomic conditions. Ratings of banks with different ownership structures are all influenced strongly by the sovereign rating, with some variation depending on the countries’ characteristics. Emerging market bank ratings are less likely to follow sovereign rating downgrades during the recent financial crisis period.     

Conditional risk premia in currency markets and other asset classes

The downside risk capital asset pricing model (DR-CAPM) can price the cross section of currency returns. The market-beta differential between high and low interest rate currencies is higher conditional on bad market returns, when the market price of risk is also high, than it is conditional on good market returns. Correctly accounting for this variation is crucial for the empirical performance of the model. The DR-CAPM can jointly rationalize the cross section of equity, equity index options, commodity, sovereign bond and currency returns, thus offering a unified risk view of these asset classes. In contrast, popular models that have been developed for a specific asset class fail to jointly price other asset classes.     

An empirical analysis of herd behavior in global stock markets

This paper examines herding behavior in global markets. By applying daily data for 18 countries from May 25, 1988, through April 24, 2009, we find evidence of herding in advanced stock markets (except the US) and in Asian markets. No evidence of herding is found in Latin American markets. Evidence suggests that stock return dispersions in the US play a significant role in explaining the non-US market’s herding activity. With the exceptions of the US and Latin American markets, herding is present in both up and down markets, although herding asymmetry is more profound in Asian markets during rising markets. Evidence suggests that crisis triggers herding activity in the crisis country of origin and then produces a contagion effect, which spreads the crisis to neighboring countries. During crisis periods, we find supportive evidence for herding formation in the US and Latin American markets.     

Correlation and return dispersion dynamics in Chinese markets

This paper studies the relation between firm-level return dispersions and correlations among Chinese stocks during periods of unusually large upward and downward swings. We analyze individual stock returns across 18 sectors and test if return dispersions and stock correlations show asymmetric patterns for extreme up and down markets. Evidence from studies on U.S. stocks suggests that equity return correlations tend to be much greater on the downside than on the upside and that the degree of comovement gets even stronger during extreme market states. However, in the case of Chinese stock market, we find that higher downside correlations apply to only stocks within the Financial sector. With the exception of Financial stocks, we find that stock correlations are significantly higher during up markets, rather than down markets. Regarding firm-level return dispersions, our findings are consistent with rational asset pricing model predictions. We find that equity return dispersions are significantly higher during periods of large price changes.     

The 52-week high momentum strategy in international stock markets

We study the 52-week high momentum strategy in international stock markets proposed by George and Hwang [George, T., Hwang, C.Y., 2004. The 52-week high and momentum investing. Journal of Finance 59, 2145-2176.]. This strategy produces profits in 18 of the 20 markets studied, and the profits are significant in 10 markets. The 52-week high momentum profits exist independently from the Jegadeesh and Titman [Jegadeesh, N., Titman, S., 1993. Returns to buying winners and selling losers: implications for market efficiency. Journal of Finance 48, 65-91.] individual stock and Moskowitz and Grinblatt [Moskowitz, T.J., Grinblatt, M., 1999. Do industries explain momentum? Journal of Finance 54, 1249-1290] industry momentum strategies. These profits do not show reversals in the long run. We find that the 52-week high is a better predictor of future returns than macroeconomic risk factors or the acquisition price. The individualism index, a proxy to the level of overconfidence, has no explanatory power to the variations of the 52-week high momentum profits across different markets. However, the profits are no longer significant in most markets once transaction costs are taken into account.     

Empirical relationship between macroeconomic volatility and stock returns: Evidence from Latin American markets

Emerging market stock returns have been characterized as having higher volatility than returns in the more developed markets. But previous studies give little attention to the fundamentals driving the reported levels of volatility. This paper investigates whether dynamics in key macroeconomic indicators like exchange rates, interest rates, industrial production and money supply in four Latin American countries significantly explain market returns. The MSCI world index and the U.S. 3-month T-bill yield are also included to proxy the effects of global variables. Using a six-variable vector autoregressive (VAR) model, the study finds that the global factors are consistently significant in explaining returns in all the markets. The country variables are found to impact the markets at varying significance and magnitudes. These findings may have important implications for decision-making by investors and national policymakers.     

Central bank intervention and the intraday process of price formation in the currency markets

We propose a novel theory of the impact of sterilized spot interventions on the microstructure of currency markets that focuses on their liquidity. We analyze the effectiveness of intervention operations in a model of sequential trading in which i) a rational Central Bank faces a trade-off between policy motives and wealth maximization; ii) currency dealers' sole objective is to provide immediacy at a cost while maintaining a driftless expected foreign currency position; and iii) adverse selection, inventory, signaling, and portfolio balance considerations are absent by assumption. In this setting, and consistent with available empirical evidence, we find that i) the mere likelihood of a future intervention—even if expected, non-secret, and uninformative—is sufficient to generate endogenous effects on exchange rate levels, to increase exchange rate volatility, and to impact bid-ask spreads; and ii) these effects are exacerbated by the intensity of dealership competition, the extent of the Central Bank's policy trade-off, and the credibility of its threat of future actions.     

Hidden liquidity: An analysis of order exposure strategies in electronic stock markets

Many stock exchanges choose to reduce market transparency by allowing traders to hide some or all of their order size. We study the costs and benefits of order exposure and test hypotheses regarding hidden order usage using a sample of Euronext-Paris stocks, where hidden orders represent 44% of the sample order volume. Our results support the hypothesis that hidden orders are associated with a decreased probability of full execution and increased average time to completion, and fail to support the alternate hypothesis that order exposure causes defensive traders to withdraw from the market. However, exposing rather than hiding order size increases average execution costs. We assess the extent to which non-displayed size is truly hidden and document that the presence and magnitude of hidden orders can be predicted to a significant, but imperfect, degree based on observable order attributes, firm characteristics, and market conditions. Overall, the results indicate that the option to hide order size is valuable, in particular, to patient traders.     

Do industries lead stock markets?

We investigate whether the returns of industry portfolios predict stock market movements. In the US, a significant number of industry returns, including retail, services, commercial real estate, metal, and petroleum, forecast the stock market by up to two months. Moreover, the propensity of an industry to predict the market is correlated with its propensity to forecast various indicators of economic activity. The eight largest non-US stock markets show remarkably similar patterns. These findings suggest that stock markets react with a delay to information contained in industry returns about their fundamentals and that information diffuses only gradually across markets.     

Volume and skewness in international equity markets

We examine the relation between trading volume and skewness in 11 international stock markets using daily and monthly data from January 1980 to August 2004. We construct single equation and VAR models of the relation between the first three moments of market returns and trading volumes. Our results show hitherto unrecognised channels of influence, and support the investor heterogeneity approach to explaining return asymmetries.     

Public information arrival: Price discovery and liquidity in electronic limit order markets

How information is translated into market prices is still an open question. This paper studies the impact of newswire messages on intraday price discovery, liquidity, and trading intensity in an electronic limit order market. We take an objective ex ante measure of the tone of a message to study the impacts of positive, negative, and neutral messages on price discovery and trading activity. As expected, we find higher adverse selection costs around the arrival of newswire messages. Negative messages are associated with higher adverse selection costs than positive or neutral messages. Liquidity increases around positive and neutral messages and decreases around negative messages. Available order book depth as well as the trading intensity increases around all news. Our results suggest that market participants possess different information gathering and processing capabilities and that negative news messages are particularly informative and induce stronger market reactions.     

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.