Related securities and price discovery: Evidence from NYSE-listed Non-U.S. stocks

In this paper we analyze whether handling related securities improves a market maker's information environment and helps to incorporate new information in stock prices. Our empirical tests are focused on New York Stock Exchange specialists and the U.S. share in price discovery of 64 British and French companies cross-listed on the NYSE. We define related securities as stocks from the same country, the same region, or other foreign stocks. We find strong evidence that a higher prominence of related stocks in the specialist portfolio is associated with a higher U.S. share in price discovery of our sample firms. We interpret our findings as evidence that concentrating market makers in similar stocks reduces information asymmetries and improves the information environment as market makers can extract information relevant to a stock from order flow to related securities. To support our argument, we show that the adverse selection component of the bid–ask spread is negatively related to the prominence of other foreign stocks in the specialist portfolio.     

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.     

Why do security prices change? A transaction-level analysis of NYSE stocks

This article develops and tests a structural model of intradayprice formation that embodies public information shocks andmicrostructure effects. We use the model to analyze intradaypatterns in bid-ask spreads, price volatility, transaction costs,and return and quote auto-correlations, and to construct metricsfor price discovery and effective trading costs. Informationasymmetry and uncertainty over fundamentals decrease over theday, although transaction costs increase. The results help explainthe U-shaped pattern in intraday bid-ask spreads and volatility,and are also consistent with the intra-day decline in the varianceof ask price changes.     

Market Making and Trading in Nasdaq Stocks

This paper examines the relations between the number of market makers, trading activity, and price improvement in Nasdaq stocks, using a model motivated by Grossman and Miller (1988). Results indicate a positive relation between the number of market makers and trading frequency, and that competition among market makers reduces effective bid-ask spreads. Results estimated using a simultaneous equations framework support the model predictions of Grossman and Miller. Results also indicate that trading frequency may be more important than trade size in determining the number of market makers.     

Market structure and microstructure, in international interest rate futures markets

We examine the role of market structure in identifying microstructure features of the NYSE.Euronext-LIFFE STIR futures market by comparing the ability of two bid-ask spread component models to explain bid-ask spreads. These two models differ only in their assumptions about whether or not market makers are present. The period we analyze includes data from pit-based trading alongside electronic market data. We explore how market structure affects the way private information influences bid-ask spreads and return volatility. A second part of our study employs intraday correlation to investigate these links in greater depth, while a third part looks at how private information and trading noise contribute to price evolution.     

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.     

Information,sell-side research,and market making

The interaction between an investment bank's research and market making arms may have important implications for the trading of a firm's stock. We investigate the impact that research has on the liquidity provided by the bank's market maker. Utilizing a large sample of Nasdaq firms, we show that market makers whose banks also provide research coverage provide more liquidity and contribute more to price discovery than do market makers without such research coverage. Finally, we show that such “affiliated” market makers are less affected by uncertainty following earnings announcements. Our results provide new evidence on the sources of liquidity improvements for Nasdaq firms, and suggest that the information produced by banks in the sell-side research process is beneficial to their market makers.     

Cross-Border Listings and Price Discovery: Evidence from U.S.-Listed Canadian Stocks

We examine the contribution of cross-listings to price discovery for a sample of Canadian stocks listed on both the Toronto Stock Exchange (TSE) and a U.S. exchange. We find that prices on the TSE and U.S. exchange are cointegrated and mutually adjusting. The U.S. share of price discovery ranges from 0.2 percent to 98.2 percent, with an average of 38.1 percent. The U.S. share is directly related to the U.S. share of trading and to the ratio of proportions of informative trades on the U.S. exchange and the TSE, and inversely related to the ratio of bid-ask spreads.     

Insider Trading and the Bid-Ask Spread

This study examines the intertemporal and cross-sectional association between the bid-ask spread and insider trading. Empirical results from the cross-sectional regression analysis reveal that market makers establish larger spreads for stocks with a greater extent of insider trading. The time-series regression analysis, however, finds no evidence of spread changes on insider trading days. These results suggest that although market makers may not be able to detect insider trading when it occurs, they protect themselves by maintaining larger spreads for stocks with a greater tendency of insider trading. The results also reveal that market makers establish larger spreads when there are unusually large transactions. In addition, this study finds that spreads are positively associated with risk and negatively with trading volume, the number of exchange listings, share price, and firm size.     

Bid,ask and transaction prices in a specialist market with heterogeneously informed traders

The presence of traders with superior information leads to a positive bid-ask spread even when the specialist is risk-neutral and makes zero expected profits. The resulting transaction prices convey information, and the expectation of the average spread squared times volume is bounded by a number that is independent of insider activity. The serial correlation of transaction price differences is a function of the proportion of the spread due to adverse selection. A bid-ask spread implies a divergence between observed returns and realizable returns. Observed returns are approximately realizable returns plus what the uninformed anticipate losing to the insiders.     

Price discovery and common factor models

If a financial asset is traded in more than one market, common factor models may be used to measure the contribution of these markets to the price discovery process. We examine the relationship between the Hasbrouck (J. Finance (50) (1995) 1175) and Gonzalo and Granger (J. Bus. Econ. Stat. 13 (1995) 27) common factor models. These two models complement each other and provide different views of the price discovery process between markets. The Gonzalo and Granger model focuses on the components of the common factor and the error correction process, while the Hasbrouck model considers each market's contribution to the variance of the innovations to the common factor. We show that the two models are directly related and provide similar results if the residuals are uncorrelated between markets. However, if substantive correlation exists, they typically provide different results. We illustrate these differences using analytic examples plus a real world example consisting of electronic communications networks (ECNs) and other Nasdaq market makers.     

INTRADAY VARIATIONS IN TRADING ACTIVITY,PRICE VARIABILITY,AND THE BID-ASK SPREAD

In this paper intraday variations in trading activity and the bid-ask spread are examined. Intraday variations in volume and price variability demonstrate a U-shaped pattern as in previous studies. However, I find a U-shaped pattern for a measure of the spread component that is related to the degree of information asymmetry between the specialist and informed traders and an inverted U-shaped pattern for the other spread component related to inventory and order costs. Two alternative explanations are given.     

The impact of designated market makers on security prices

This paper is divided into two distinct parts. Part I, Empirical Evidence, tests a previously formulated variance, thinness relationship for security returns. First quarter 1972 daily returns variance is regressed on market value of shares, share price, trading activity, sales variance, and institutional holdings for 178 firms selected by stratified random sampling from AMEX and NYSE (specialist exchanges), and from Tokyo and Rio de Janeiro (non-specialist exchanges). The principal finding is that returns variance and market value are inversely related on non-specialist exchanges, but not on specialist exchanges; this difference is attributed to specialists' impact. Part II, Policy Proposals, discusses the manner in which designated market makers may be effectively incorporated into a continuous auction exchange. Issues discussed include: desirability of price stabilization, transfers implicit in the existing U.S. specialist system, consolidation and public availability of the limit order book, number of designated market makers for a security, competitive bidding, and compensation for performing the price stabilization function. Stabilization is modeled as an external economy, and specific policy proposals for internalizing it are advanced.     

Dynamic price discovery

This article analyzes the dynamic process of price discovery in a competitive securities market where investors are equally informed about the fundamental determinants of an asset's end-of-period value but, because they do not know each other's wealth positions, do not know the equilibrium price of shares at the start of a current trading session. Because a large number of participants is assumed, issues concerning market impact and market manipulation are avoided. As trading progresses, participants update their expectations of an asset's equilibrium value. As they do so, price can either converge to a new level or, following a run, revert back to a previous level. This implies that, in clusters of adjacent prices, price changes are more apt to be predominantly of like sign (positive or negative) than would be the case under random walk with a bid-ask spread. Moreover, reversals, when they do occur, should be larger than continuations. An examination of 1988 transactions data for the 30 Dow Jones Industrial stocks shows that this is indeed the case. With the effect of the bid-ask spread removed, first-order autocorrelation coefficients are found to be positive.     

Dispersed Trading and the Prevention of Market Failure: the Case of the Copenhagen Stock Exchange

With augmented demands on power grids resulting in longer and larger blackouts combined with heightened concerns of terrorist attacks, trading institutions and policy makers have widened their search for systems that avoid market failure during these disturbing events. We provide insight into this issue by examining trading behaviour at the Copenhagen Stock Exchange during a major blackout. We find that although market quality declined, markets remained functional and some price discovery occurred during the blackout period suggesting that the NOREX structure of interlinked trading systems combined with widely dispersed trading locations may be a viable means of protection against market failure during massive power disruptions or terrorist attacks.     

Discrete-time option pricing with stochastic liquidity

Classical option pricing theories are usually built on the law of one price, neglecting the impact of market liquidity that may contribute to significant bid-ask spreads. Within the framework of conic finance, we develop a stochastic liquidity model, extending the discrete-time constant liquidity model of Madan (2010). With this extension, we can replicate the term and skew structures of bid-ask spreads typically observed in option markets. We show how to implement such a stochastic liquidity model within our framework using multidimensional binomial trees and we calibrate it to call and put options on the S&P 500.     

WINNERS AND LOSERS ON NYSE: A RE-EXAMINATION USING DAILY CLOSING BID-ASK SPREADS

We study a sample of NYSE stocks that experienced a large one-day price change during 1992 and were reported as daily largest percentage gainers and largest percentage losers in the Wall Street Journal. The sample indicates significant reversals during the immediate post-announcement period. We test for market efficiency by using bid-ask spreads obtained from the transactions data for the days immediately after the announcement. The overall results indicate that the returns during the reversal period are less than the average bid-ask spread during the same time. We also find that major losers, firms with ?20 percent to ?50 percent event-date abnormal returns, experience price reversals generating returns that are significantly greater than the average bid-ask spread during that period. We interpret this result as consistent with the overreaction hypothesis. A test of a trading rule to exploit this overreaction is not profitable, providing support for weak-form market efficiency.     

Microstructure and reverse stock splits

In this paper we show that, similar to NYSE/AMEX stocks, NASDAQ stocks exhibit significant ex date returns for reverse stock splits. Although the 10-day cumulative return after the ex date is close to –10%, this does not violate market efficiency, because the average bid-ask spread for the reverse split stock is at least double this return. We also document that these large negative returns are mostly due to a drop in the ask price while bid prices barely change at all. Furthermore, the ex date returns are negatively related to trading volume.These results suggest that there is abnormal selling and a significant buildup of market makers' inventories near the ex date. To reduce the inventory buildup, market makers lower ask prices to induce buying by investors, resulting in the observed negative returns. Lowering bid prices, an alternative strategy for reducing inventories, is not attractive to market makers due to competitive factors and the reduction of commissions associated with a smaller number of transactions. Notably, selling investors have no incentives to sell their stocks early to avoid the observed negative ex date return, since this return is largely an ask price phenomenon and does not represent realized returns to sellers.     

Liquidity of the CBOE Equity Options

We examine the CBOE option market depth and bid-ask spreads. Absence of price effects surrounding large option trades suggests excellent market depth. However, bid-ask spreads for the CBOE options and the NYSE stocks are nearly equal, even though an average option is equivalent to less than half a stock plus borrowing. We explain this tradeoff between market depth and bid-ask spreads on the CBOE and the NYSE by differences in market mechanisms. We also show that the adverse-selection component of the option spread, which measures the extent of information-related trading on the CBOE, is very small.     

Macroeconomic Announcements and the Distribution of Price-Endings in the U.S. Treasury Market

We investigate how new information impacts quote clustering in the bond market. We find that clustering, along with quote activity, price volatility and bid-ask spreads, increases sharply in the minutes following releases of macroeconomic news. Each returns to near-normal levels within the hour. Effects are strongest for more liquid on-the-run notes and for the announcements typically associated with substantial information flow. The strong positive comovement of clustering, quote activity, price volatility, and bid-ask spreads supports the conclusion that innovations of these variables are endogenous to the arrival and incorporation of information into prices.