Forward interest rate premium and asymmetric adjustment: Evidence from 16 countries

This paper examines the ability of the forward premium to provide an unbiased estimate of the future spot rate allowing for potential asymmetries. Extant evidence suggests that forward rates provide a biased predictor of future spot rates. Examining the forward premium for 16 countries, only for 2 countries does the linear expectations hypothesis holds. For the remaining countries, results generally support the view that the larger the forward premium the better a predictor for future spot rates it is, however, this result is not unique across all countries. Furthermore, although the asymmetric model improves data fit over the linear model, only in four cases does the model support an unbiased predictor interpretation. Further research is therefore required to understand the nature of this relationship, not least given the importance of correctly priced forward and long rates in terms of expected returns to future investments and the conduct of monetary policy.     

High frequency lead/lag relationships — Empirical facts

Lead/lag relationships are an important stylized fact at high frequency. Some assets follow the path of others with a small time lag. We provide indicators to measure this phenomenon using tick-by-tick data. Strongly asymmetric cross-correlation functions are empirically observed, especially in the future/stock case. We confirm the intuition that the most liquid assets (short intertrade duration, narrow bid/ask spread, small volatility, high turnover) tend to lead smaller stocks. However, the most correlated stocks are those with similar levels of liquidity. These lead/lag relationships become more and more pronounced as we zoom on significant events. We reach 60% of accuracy when forecasting the next midquote variation of the lagger using only the past information of the leader, which is significantly better than using the information of the lagger only. However, a naive strategy based on market orders cannot make any profit of this effect because of the bid/ask spread.     

Share repurchase tender offers and bid–ask spreads

This paper examines the impact of share repurchase tender offers on the market microstructure. We find that there is a temporary reduction in the bid–ask spread, and a temporary increase in volume and quotation depth during the offer period. Our evidence suggests that the bid–ask spread is asymmetric during the offer period with the bid-side spread smaller than the ask-side spread. The temporary reduction in the spread around offers is consistent with the competing-market-maker hypothesis which predicts that the intensified competition for the market maker raises bid prices and narrows the spread asymmetrically during the offer period.     

Portfolio risk,adjustment costs,and security dealers' bid/ask spreads

This article notes that dealers' bid/ask spreads should vary directly with their costs of adjusting to inventory imbalances. Thus, well-diversified dealers are expected to quote lower bid/ask spreads on stocks with substantial total risk caused by undiversifiable risk. Furthermore, the effect of systematic risk on bid/ask spreads should be negligible if dealers are compensated for systematic risk by market returns. This article shows that, empirically, bid/ask spreads of OTC stocks are insensitive to the systematic risk of individual stocks—even when only stocks with stable betas are considered. Furthermore, bid/ask spreads are not sensitive to changes in market variance, as would be expected if systematic risk affected spreads. While unsystematic risk affects bid/ask spreads, its effect is pronounced for stocks traded by small, undiversified dealers. If stocks are only traded by large dealers with low diversification costs, unsystematic risk does not affect bid/ask spreads.     

The forward exchange rate and the prediction of the future spot rate: Empirical evidence

This paper examines the characteristics and evaluates the record of the forward exchange rate as a predictor of the future spot rate of three European currencies during the recent period of floating rates. The forward rate (for 1, 3 and 6 months) is compared to a simple predictor of ‘no change’ extrapolations (i.e., a Martingale model) by the use of Theil's inequality ratios. Theil's measures are then applied to assess the relative importance of the various sources of the forward's prediction errors, and the efficiency of the forecast is tested. The results show that the forward rate, while generally producing unbiased forecasts, fails to track the fluctuations in future spot rates and poorly reflects their variations. Further, it does not perform better than the current spot rate in predicting the future spot rate for all the examined forecast leads. Thus its usefulness for the purpose of business decisions is questioned.     

A multiple-curve Lévy forward rate model in a two-price economy

An advanced Heath–Jarrow–Morton forward rate model driven by time-inhomogeneous Lévy processes is presented which is able to handle the recent development to multiple curves and negative interest rates. It is also able to exploit bid and ask price data. In this approach in order to model spreads between curves for different tenors, credit as well as liquidity risk is taken into account. Deterministic conditions are derived to ensure the positivity of spreads and thus the monotonicity of the curves for the various tenors. Valuation formulas for standard interest rate derivatives such as caps, floors, swaptions and digital options are established. These formulas can be evaluated numerically very fast using Fourier-based valuation methods. In order to exploit bid and ask prices we develop this approach in the context of a two-price economy. Explicit formulas for bid as well as ask prices of the derivatives are stated. A specific model framework based on normal inverse Gaussian and Gamma processes is proposed which allows for calibration to market data. Calibration results are presented based on multiple-curve bootstrapping and cap market quotes. We use data from September 2013 as well as September 2016. The latter is of particular interest since rates were deep in negative territory at that time.     

Structural changes,bid–ask spread composition and tick size in inter-bank futures trading

This paper studies a period containing three major structural changes, which constitute a natural experiment in the NYSE.Euronext-LIFFE European short-term interest rate (STIR) futures market. These changes comprise (1) a 50% reduction in minimum tick size for the most heavily traded contract, (2) European Monetary Union and (3) the transition from open outcry to electronic trading. We analyse a number of microstructure features of the four largest European interest rate futures contracts throughout this period. In particular, we focus on bid–ask spread composition using a recent model which is appropriate for this market structure. Our analysis identifies the tick size as the largest bid–ask spread component in almost every instance, which suggests that participants in this STIR future market might benefit from a reduction in minimum tick sizes.     

The economic determinants of interest rate option smiles

We address three questions relating to the interest rate options market: What is the shape of the smile? What are the economic determinants of the shape of the smile? Do these determinants have predictive power for the future shape of the smile and vice versa? We investigate these issues using daily bid and ask prices of euro (€) interest rate caps/floors. We find a clear smile pattern in interest rate options. The shape of the smile varies over time and is affected in a dynamic manner by yield curve variables and the future uncertainty in the interest rate markets; it also has information about future aggregate default risk. Our findings are useful for the pricing, hedging and risk management of these derivatives.     

Forward exchange market unbiasedness: the case of the Australian dollar since 1984

This paper implements a robust statistical approach to regression with non-stationary time series. The methods were recently developed in other work and are briefly exposited here. They allow us to perform regressions in levels with non-stationary time series data, they accommodate data distributions with heavy tails and they permit serial dependence and temporal heterogeneity of unknown form in the equation errors. With these features the methods are well suited to applications with frequently sampled exchange rate data, which generally display all of these empirical characteristics. Our application here is to daily data on spot and forward exchange rates between the Australian and US dollars over the period 1984–1991, following the deregulation of the Australian foreign exchange market. We find big differences between the robust and the non-robust regression outcomes and in the associated statistical tests of the hypothesis that the forward rate is an unbiased predictor of the future spot rate. The robust tests reject the unbiasedness hypothesis but still give the forward rate an important role as a predictor of the future spot rate.     

Transaction duration and asymmetric price impact of trades—Evidence from Australia

This paper investigates the asymmetric price impact of buyer and seller initiated trades and the informational role of the trade duration. Using trade data from the Australian Stock Exchange (ASX), our results indicate that buyer initiated trades increase the ask price more than the bid price, and seller initiated trades decrease the bid price more than the ask price. The transaction duration is modeled in a Box-Cox ACD framework. The unexpected portion of the duration is found to play a more significant role in causing price impact in both purchases and sales than the expected duration. A trade shortly after the previous trade results in higher price impact than one after a long period. We found evidence that increased trading activity is associated with larger price impact, therefore implying a higher degree of information-based trading.     

Information asymmetry of fair value accounting during the financial crisis

We examine whether US banks’ fair value net assets, measured according to the three-level hierarchy introduced in SFAS 157, are associated with information asymmetry during the 2008 financial crisis. Our results show that bid–ask spread, a proxy for information asymmetry, is positively associated with fair value net assets, and the degree of association is contingent upon the three-level hierarchy, with bid–ask spreads being lowest for Level 1 (the most transparent valuation inputs) and highest for Level 3 (the least observable). Also, there is some evidence that SFAS 157 led to a reduction in bid–ask spread, and we find that quarterly changes in Level 1 and Level 2 fair value net assets are significantly associated with changes in bid–ask spread in 2008 when the spread was rapidly rising, but not in 2009 when it was falling. Our findings suggest that the three-level hierarchy under SFAS 157 provides investors with useful information, and fair value is associated with uncertainty, as measured by bid–ask spread, before and during the financial crisis.     

Option trading after the opening bell and intraday stock return predictability

Prior literature finds that information is reflected in option markets before stock markets, but no study has explored whether option volume soon after market open has predictive power for intraday stock returns. Using novel intraday signed option-to-stock volume data, we find that a composite option trading score (OTS) in the first 30 min of market open predicts stock returns during the rest of the trading day. Such return predictability is greater for smaller stocks, stocks with higher idiosyncratic volatility, and stocks with higher bid–ask spreads relative to their options’ bid–ask spreads. Moreover, OTS is a significantly stronger predictor of intraday stock returns after overnight earnings announcements. The evidence suggests that option trading in the 30 min after the opening bell has predictive power for intraday stock returns.     

On the informational content of spot and forward exchange rates

In foreign exchange markets, efficiency tests have typically been applied to the forward rate on the argument that the forward rate should be a good proxy for the unobservable market expectations of future spot rates. The present study offers innovations in two directions. First we utilize a data set which consists of daily observations on spot and forward exchange rates. This allows us to match the forward contract with the exact settlement date and to create a large number of non-overlapping data sets. Second, and more importantly, we show that in general the current spot rate is a ‘better’ predictor of the future spot rate than is the current forward rate of appropriate maturity.     

Arbitrage violations and implied valuations: the option market

The ideas presented in this paper are those of the authors and not necessarily reflect the views of the National bank of Canada. Both authors thank the National Bank of Canada and the SSHRC of Canada for their help. Thanks are also due to Professor Y. Tian for his comments, and for participating, together with students of the Financial Engineering program at York University, in the data preparation and the execution of the Matlab programs. In this paper, we propose a necessary and sufficient condition for bid and ask prices of European options to be free of arbitrage, and derive from it an efficient numerical methodology to determine its satisfaction by a given set of prices. If the bid and ask prices satisfy the no-arbitrage (NA) condition, our methodology produces a vector of NA prices that lie between the bid and ask prices. Otherwise, our methodology generates a vector of arbitrage-free prices that is as close as possible, in some sense, to the bid–ask strip. The arbitrage-free prices detected by our methodology render the commonly used practice of using mid-points and then ‘cleaning’ arbitrage from them as unnecessary. Moreover, a vector of ‘cleaned’ prices obtained from mid-point prices may be outside the bid–ask spread even in an arbitrage-free market and, hence, in this case will not be representative of the current market. A new procedure of estimating implied valuation operators is also suggested here. This procedure is rooted in the economic properties of put and call prices and is based on Phillips and Taylor's approximation of a convex function. This approach is superior to common estimation techniques in that it produces an analytical expression for the implied valuation operator and is not data intensive as some other studies. Empirical findings for the new methods are documented and their economic implications are discussed.     

Market-making costs in Treasury bills: A benchmark for the cost of liquidity

We focus on market-making costs by examining the daily bid–ask spreads for off-the-run, one-month Treasury bills around two liquidity-changing events. Event one, Salomon Brothers’ supply shock, results in a roughly 2.5-basis-point increase in the spread because of an increase in ask prices; and event two, the Long-Term Capital Management demand shock, results in a doubling of the spread because of a decrease in bid prices. Our results provide a benchmark for researchers examining bid–ask spreads of securities that include a liquidity premium, a risk premium, and an asymmetric information premium.     

Relative performance of bid–ask spread estimators: Futures market evidence

The issue of transaction costs is the mainstay of the equity market microstructure. Research in the microstructure of futures markets has lagged behind. A primary reason is that futures exchanges in the U.S. do not record bid–ask quotes, requiring these costs to be imputed from transaction price data. A reliable estimator of bid–ask spreads would significantly enhance microstructure research in futures markets. Unique intraday data from the Sydney Futures Exchange (SFE) that include both transaction prices and bid–ask spreads allow us to compare bid–ask spread estimation techniques proposed in the literature against the benchmark of actual spreads in a futures market, and thus identify the best-performing estimator. To maximize relevance, we impose all the constraints that apply in U.S. futures data to perform our estimations. We find that the four bid–ask spread estimators considered significantly underestimate the actual spreads. However, simple moments-based estimators perform better in predicting spreads.     

The role of private information in return volatility,bid–ask spreads and price levels in the foreign exchange market

Trading volume and order flow have both been closely associated with informed trader activity in the market microstructure literature. Using theory that explains regular intraday patterns in trading data, we transform these two variables into proxies for private information and examine their relationships with bid–ask spreads and return volatility. We use a unique and unusually rich high-frequency intraday dataset from the world's largest financial market, namely, the electronic inter-dealer spot foreign exchange market. Our analysis takes account of institutional features peculiar to this order-driven market. Our empirical results strongly affirm our theoretical understanding of how these markets work. They also reveal how the structure of the inter-dealer spot FX market affects exchange rate volatility. Finally, we also explore how private information contributes to the evolution of prices.     

The relationship between bid–ask spreads and holding periods: The case of Chinese A and B shares

The Chinese stock markets for A (domestic) shares and B (foreign) shares were completely separated. This study examines the relationship between spreads and holding periods across these segmented markets on the same set of firms. Our major findings are as follows. (1) There is a positive relationship between holding periods and bid–ask spreads in the Chinese stock market. (2) Investors' sensitivity toward liquidity is approximately the same in the A and B share markets, even though bid–ask spreads are substantially different across the two markets. These results provide strong support for the theoretical argument of Amihud and Mendelson [Amihud, Y., & Mendelson, H. (1986). Asset pricing and the bid–ask spread. Journal of Financial Economics, 17, 223–249.] that stocks with higher spreads tend to be held by long-term investors. Evidence also suggests that liquidity has a role in explaining the B share discount, although the results are less than conclusive.     

The relationship between bid–ask spreads and holding periods: The case of Chinese A and B shares

The Chinese stock markets for A (domestic) shares and B (foreign) shares were completely separated. This study examines the relationship between spreads and holding periods across these segmented markets on the same set of firms. Our major findings are as follows. (1) There is a positive relationship between holding periods and bid–ask spreads in the Chinese stock market. (2) Investors' sensitivity toward liquidity is approximately the same in the A and B share markets, even though bid–ask spreads are substantially different across the two markets. These results provide strong support for the theoretical argument of Amihud and Mendelson [Amihud, Y., & Mendelson, H. (1986). Asset pricing and the bid–ask spread. Journal of Financial Economics, 17, 223–249.] that stocks with higher spreads tend to be held by long-term investors. Evidence also suggests that liquidity has a role in explaining the B share discount, although the results are less than conclusive.     

The Optimal Pricing Policy of a Monopolistic Marketmaker in the Equity Market

This paper presents a stochastic optimization model for marketmaking in security markets with a single dealer. Buy and sell orders are assumed to arrive at rates that are functions of the ask and bid prices. The dealer incurs both proportional and fixed transaction costs as well as portfolio costs. Methods of dynamic programming and semi-Markov Decision Processes are used to characterize optimal pricing policies and to perform sensitivity analysis. Both bid and ask prices are nonincreasing functions of the dealer's inventory. Spread is unrelated to inventory position but positively related to order size. Computational examples demonstrate various results.