Liquidity Provision and Noise Trading: Evidence from the "Investment Dartboard" Column

How does increased noise trading affect market liquidity and trading costs? We use The Wall Street Journal's “Investment Dartboard” column, which stimulates noise trading, as a natural experiment to evaluate models of the bid-ask spread. We find that substantial increases in trading volume and significant but temporary abnormal returns occur when analysts recommend stocks in this column, especially when recommendations come from analysts with successful contest track records. We also find an increase in liquidity and a decrease in the adverse selection component of the bid-ask spread.     

Liquidity,liquidity risk,and information flow: Lessons from an emerging market

This paper examines the role of public and private information flows in intraday liquidity and intraday liquidity risk in the Tunisian stock market. Our empirical results are based on ARMA and GARCH-type models and show that, for major Tunisian stocks, gradually elapsed public information together with gradually elapsed private information in the market is the dominant factor in liquidity improvements in the Tunisian stock market. Liquidity improvements are generated by a decrease in the bid-ask spread accompanied by an increase in the depth at best limit. Our results clearly indicate that the arrival of public information in a sequential manner is the dominant factor generating increases in liquidity risk related to the bid-ask spread, while the advent of private information in a contemporaneous manner is the dominant factor generating increases in liquidity risk related to the depth at best limit. Additionally, our results show that liquidity risk persistence disappears when trading volume and order imbalance are included as explanatory variables in the conditional variance equation.     

Trade Disclosure,Information Learning and Securities Market Performance

In this paper we examine the effect of information disclosure on securities market performance when liquidity traders are able to acquire information about inside trading. We show that the bid-ask spread increases with the liquidity trader's learning efficiency, which is greater when trade information is disclosed. The bid-ask spread is always higher when trade information is not disclosed. However, the discrepancy between the bid-ask spreads with and without information disclosure narrows when the learning efficiency increases. We also show that the gains of the informed traders in a market without trade information disclosure are reduced in the presence of the liquidity trader's learning. Nevertheless, liquidity traders do not necessarily benefit from increased transparency. In particular, liquidity traders may face higher trading costs.     

THE CROSS-SECTIONAL EFFECTS OF OPTION LISTING ON FIRM STOCK RETURN VARIANCES

We develop a set of hypotheses to explain cross-sectional differences in variance changes associated with option listing. Transactions variance is decomposed into three components: the bid-ask spread, return autocorrelations, and intrinsic variance. Each is investigated separately. We find support for hypotheses that link: (1) changes in dealer transactions costs to changes in the bid-ask spread following option listing; (2) changes in the quantity and quality of information and the value of new information to movements of the return autocorrelation structure toward zero; and (3) changes in trading volume and the clientele that trades the underlying security to changes in intrinsic variance following option listing.     

Liquidity skewness in the London Stock Exchange

We study liquidity on the London Stock Exchange. We find that the average bid-ask spread declines, but that the skewness of the spread increases. These results are robust to firm size, trading volume and price level. Our findings hold when the bid-ask spread is estimated utilising high frequency data. We find that the bid-ask spread prior to earnings announcements dates is significantly higher than that of post earnings announcements, suggesting that asymmetric information has driven the increase in liquidity skewness. We also find that the effect of earnings announcements is more pronounced in the 2007 global financial crisis, consistent with the notion that extreme market downturns amplify asymmetric information. Our overall evidence also implies that increased competition and transparent trading environments limit market makers' abilities to cross-subsidize bid-ask spreads between periods of high and low levels of asymmetric information.     

Liquidity and market efficiency: A large sample study

Chordia et al. (2008, hereafter CRS) examine short horizon return predictability from past order flows of large, actively traded NYSE firms across three tick size regimes and conclude that higher liquidity facilitates arbitrage trading which enhances market efficiency. We extend CRS to a comprehensive sample of all NYSE firms and examine the dynamics between liquidity and market efficiency during informational periods. Our results indicate that although all NYSE firms experience an overall improvement in market efficiency across periods of different tick size regimes, this improvement varies significantly across the portfolios of sample companies formed on the basis of trading frequency, market capitalization, and trading volume. After controlling for these factors, we further document a positive association between a continuous measure of liquidity and market efficiency, and show that this effect is amplified during periods that contain new information, as reflected in high adverse selection component of the bid-ask spread.     

FURTHER EVIDENCE ON THE LIQUIDITY EFFECTS OF STOCK SPLITS AND STOCK DIVIDENDS

Currently, there is a limited amount of empirical evidence suggesting that stock splits are associated with a decline in trading liquidity. This evidence directly contrasts with managements' professed intentions for undertaking a split. The evidence to date, however, is of a short-run nature. This study reexamines the liquidity effects of stock splits and stock dividends by assessing both their short- and long-term effects on trading liquidity (i.e., proportional trading volume and percentage bid-ask spreads). The results suggest that stock dividends are associated with decreased proportional trading volume in both the short term and long term, but stock splits are not. The results also indicate that neither stock splits nor stock dividends have an effect on percentage bid-ask spreads.     

Liquidity in auction and specialist market structures: Evidence from the Italian bourse

Several studies find that bid-ask spreads for stocks listed on the NYSE are lower than for stocks listed on NASDAQ. While this suggests that specialist market structures provide greater liquidity than competing dealer markets, the nature of trading on the NYSE, which comprises a specialist competing with limit order flow, obfuscates the comparison. In 2001, a structural change was implemented on the Italian Bourse. Many stocks that traded in an auction market switched to a specialist market, where the specialist controls order flow. Results confirm that liquidity is significantly improved when stocks commence trading in the specialist market. Analysis of the components of the bid-ask spread reveal that the adverse selection component of the spread is significantly reduced. This evidence suggests that specialist market structures provide greater liquidity to market participants.     

New evidence on the price and liquidity effects of the FTSE 100 index revisions

We study the price and liquidity effects following the FTSE 100 index revisions. We employ the standard GARCH(1,1) model to allow the residual variance of the single index model (SIM) to vary systematically over time and use a Kalman filter approach to model SIM coefficients as a random walk process. We show that the observed price effect depends on the abnormal return estimation methods. Specifically, the OLS-based abnormal returns indicate that the price effect associated with the index revision is temporary, whereas both SIM with random coefficients and GARCH(1,1) model suggest that both additions and deletions experience permanent price change. Added (removed) stocks exhibit permanent (temporary) change in trading volume and bid-ask spread. The analysis of the spread components suggests that the permanent change associated with additions is a result of non-information-related liquidity. We interpret the permanent price effect of additions and deletions combined with the permanent (temporary) shift in liquidity of added (removed) stocks as evidence in favour of the imperfect substitution hypothesis with some non-information-related liquidity effects in the case of additions.     

The optimal bid-ask price strategies of high-frequency trading and the effect on market liquidity

We propose a model for determining the optimal bid-ask spread strategy by a high-frequency trader (HFT) who has an informational advantage and receives information about the true value of a security. We employ an information cost function that includes volatility and the volume of the asset. Subsequently, we characterize the optimal bid-ask price strategies and obtain a stable bid-ask spread. We assume that orders submitted by low-frequency traders (LFTs) and news events arrive at the market with Poisson processes. Additionally, our model supports the trading of the two-sided quote in one period. We find that more LFTs and a higher exchange latency both hurt market liquidity. The HFT prefers to choose a two-sided quote to gain more profits while cautiously chooses a one-sided quote during times of high volatility. The model generates some testable implications with supporting empirical evidence from the NASDAQ-OMX Nordic Market.     

Stock repurchases and treasury share sales: Do they stabilize price and enhance liquidity?

Can companies reduce the volatility and increase the liquidity of their stocks by trading them? In the context of the Italian stock market, where companies have far more leeway to sell as well as buy their own stocks than in the U.S., the answer is yes. We examine the effects of trading (open-market share repurchases and treasury shares sales) on liquidity (bid-ask spread) and volatility (return variance). Further, we examine the impact of shareholder approvals of repurchase programs on liquidity and volatility. We find clear evidence that trading increases liquidity and reduces volatility. These results are consistent with our analysis of the motives Italian companies give for making share repurchases.     

Trading Patterns and Prices in the Interbank Foreign Exchange Market

The behavior of quote arrivals and bid-ask spreads is examined for continuously recorded deutsche mark-dollar exchange rate data over time, across locations, and by market participants. A pattern in the intraday spread and intensity of market activity over time is uncovered and related to theories of trading patterns. Models for the conditional mean and variance of returns and bid-ask spreads indicate volatility clustering at high frequencies. The proposition that trading intensity has an independent effect on returns volatility is rejected, but holds for spread volatility. Conditional returns volatility is increasing in the size of the spread.     

Market Response to Liquidity Improvements: Evidence from Exchange Listings

The study examines a sample of 895 stocks that moved from Nasdaq to the New York Stock Exchange or to the American Stock Exchange (Amex) between 1971 and 1994. We show how various measures of liquidity such as the bid‐ask spread, trading volume, and stock price precision improve in somewhat different ways upon transfer to NYSE (Amex). We also find that reductions in trading costs (percentage spread) and in pricing error volatility (Hasbrouck's σ₅) can explain most of stock market's positive response to exchange listing. Thus, liquidity has many facets and cannot be represented by the bid‐ask spread alone.     

DEALER BID-ASK SPREADS AND OPTIONS TRADING ON OVER-THE-COUNTER STOCKS

In this study the impact of option listings on bid-ask spreads for over-the-counter stocks is examined. Option listings are hypothesized to impact spreads by affecting the inventory-holding cost and/or the informed risk component of spreads. Univariate tests reveal that the commencement of options trading is accompanied by a statistically significant decline in percentage spreads. In addition, it is found that there is a significant rise in the average daily stock trading volume in the post-option-listing period, while there is no significant change in variance of the underlying stock returns in the short term. Regression results indicate that some stocks experience a decline in spreads even after controlling for changes in inventory-holding costs. The univariate and regression results taken in conjunction indicate a favorable impact of option listings on both the inventory-holding cost and informed-trading risk components of spread determinants. The combined evidence suggests that initiation of options trading enhances the overall liquidity of the underlying stock.     

Trading and Liquidity on the Tokyo Stock Exchange: A Bird's Eye View

The trading mechanism for equities on the Tokyo Stock Exchange (TSE) stands in sharp contrast to the primary mechanisms used to trade stocks in the United States. In the United States, exchange-designated specialists have affirmative obligations to provide continuous liquidity to the market. Specialists offer simultaneous and tight quotes to both buy and sell and supply sufficient liquidity to limit the magnitude of price changes between consecutive transactions. In contradistinction, the TSE has no exchange-designated liquidity suppliers. Instead, liquidity is provided through a public limit order book, and liquidity is organized through restrictions on maximum price changes between trades that serve to slow down trading. In this article, we examine the efficacy of the TSE's trading mechanisms at providing liquidity. Our analysis is based on a complete record of transactions and best-bid and best-offer quotes for most stocks in the First Section of the TSE over a period of 26 months. We study the size of the bid-ask spread and its cross-sectional and intertemporal stability; intertemporal patterns in returns, volatility, volume, trade size, and the frequency of trades; and market depth based on the response of quotes to trades and the frequency of trading halts and warning quotes.     

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.     

Option pricing and the martingale restriction

In the absence of frictions, the value of the under-lying assetimplied by option prices must equal its actual market value.With frictions, however, this requirement need not hold. UsingS&P 100 index options data, I find that the implied costof the index is significantly higher in the options market thanin the stock market, and is directly related to measures oftransaction costs and liquidity. I show that the Black-Scholesmodel has strong bid-ask spread, trading volume, and open interestbiases. Option pricing models that relax the martingale restrictionperform significantly better.     

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.     

Internal control reporting and market liquidity

We investigate the impact of the Sarbanes-Oxley Act of 2002 (SOX) on information asymmetry by analyzing the relation between SOX Sections 302 and 404 control reports and market liquidity using bid-ask spreads. Lower market liquidity indicates higher levels of information asymmetry implying that market participants perceive financial statement misstatement risk is higher. If SOX disclosures contain relevant information, then one would expect firms reporting internal control material weaknesses to have lower market liquidity. Accordingly, we find that market liquidity is lower (i.e., bid-ask spreads are higher) for firms reporting ineffective control compared to firms reporting effective control using either annual SOX 404 internal control reports or quarterly SOX 302 disclosure control reports, which suggests that SOX 302 and 404 reports provide useful information for identifying firms with a higher risk of financial statement misstatement. However, we do not find consistent results using two alternative liquidity measures: trading volume and market quality indices. We then examine whether changes in control reports are associated with changes in market liquidity. We generally do not find that firms with improved (deteriorated) control reports experience a larger decrease (increase) in bid-ask spreads or larger increases (decreases) in trading volume and market quality indices compared to other firms, suggesting that market participants do not discern a change in information asymmetry when the effectiveness of internal controls over financial reporting changes.     

Adverse selection, volume and transactions around dividend announcements in a continuous auction system

We show that liquidity providers do not significantly respond to changes in information asymmetry risks, at least when we analyse their trading behaviour around dividend announcements of a representative sample of stocks in a continuous auction trading mechanism. the implicit bid-ask spread does not seem to change beyond what is normally conveyed through an increased number of transactions. We also document that the information in the trading behaviour of investors is primarily contained in the number of daily transactions.