Earnings Metrics,Information Processing,and Price Efficiency in Laboratory Markets

An enduring issue in financial reporting is whether and how salient summary measures of firm performance (“earnings metrics”) affect market price efficiency. In laboratory markets, we test the effects of salient earnings metrics, which vary in how they combine persistent and transitory elements, on investor information search, beliefs about value, offers to trade, and market price efficiency. We find that including transitory elements in salient earnings metrics causes traders to search unnecessarily for further information about these elements and to overestimate their effect on fundamental value relative to a rational benchmark. In contrast, separately displaying persistent elements in earnings increases the accuracy of traders’ value estimates. Prices generally reflect traders’ beliefs about value, and prices are most efficient when transitory elements are excluded from earnings metrics entirely. Our study contributes to research on salience effects in financial reporting by showing that including transitory elements in salient earnings metrics causes inefficient information search and biased beliefs about value that can aggregate to affect market prices. We also contribute to research in experimental markets by showing that redundant disclosure is not always beneficial; redundant disclosure of transitory earnings elements, in particular, appears to have negative consequences for investor behavior and market efficiency.     

ANALYST REPUTATION,DEALER AFFILIATION,AND MARKET MAKING

We investigate the effects of analysts' affiliation and reputation on dealers' market making activities. We find that for a given stock, dealers who have affiliated analysts covering the stock quote and trade more aggressively than those who do not have any affiliated analysts. More important, the reputation of affiliated analysts plays an additional role in the affiliated dealer's quote and trade behavior. Dealers with affiliated star analysts post more aggressive quotes and have larger market shares than dealers with affiliated nonstar analysts. Although dealers who post more aggressive quotes also induce affiliated star analysts to cover the stocks, the positive effect of analyst reputation on the affiliated dealers' quote aggressiveness remains significant and robust after controlling for potential endogenous and simultaneous problems.     

Financial Markets Where Traders Neglect the Informational Content of Prices

We model a financial market where some traders of a risky asset do not fully appreciate what prices convey about others' private information. Markets comprising solely such “cursed” traders generate more trade than those comprising solely rationals. Because rationals arbitrage away distortions caused by cursed traders, mixed markets can generate even more trade. Per‐trader volume in cursed markets increases with market size; volume may instead disappear when traders infer others' information from prices, even when they dismiss it as noisier than their own. Making private information public raises rational and “dismissive” volume, but reduces cursed volume given moderate noninformational trading motives.     

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.     

Consolidation, fragmentation, and the disclosure of trading information

It is commonly believed that fragmented security markets havea natural tendency to consolidate. This article examines thisbelief, focusing on the effect of disclosing trading informationto market participants. We show that large traders who placemultiple trades can benefit from the absence of trade disclosurein a fragmented market, as can dealers who face less price competitionthan in a unified market. Consequently, a fragmented marketneed not coalesce into a single market unless trade disclosureis mandatory. We also compare and contrast fragmented and consolidatedmarkets. Fragmentation results in higher price volatility andviolations of price efficiency.     

Strategic trading and learning about liquidity

Many practitioners point out that the speculative profits of institutional traders are eroded by the difficulty in gauging the price impact of their trades. In this paper, we develop a model of strategic trading where speculators face such a dilemma because of incomplete information about time-varying market liquidity. Unlike the competitive market makers that they trade against, informed traders do not know the distribution of liquidity (“noise”) trades. Instead, they have to learn about liquidity from past prices and trading volume. This learning implies that strategic trades and market statistics such as informational efficiency are path-dependent on past market outcomes. Our paper also has normative implications for practitioners.     

Volume, Volatility, Price, and Profit When All Traders Are Above Average

People are overconfident. Overconfidence affects financial markets. How depends on who in the market is overconfident and on how information is distributed. This paper examines markets in which price-taking traders, a strategic-trading insider, and risk-averse marketmakers are overconfident. Overconfidence increases expected trading volume, increases market depth, and decreases the expected utility of overconfident traders. Its effect on volatility and price quality depend on who is overconfident. Overconfident traders can cause markets to underreact to the information of rational traders. Markets also underreact to abstract, statistical, and highly relevant information, and they overreact to salient, anecdotal, and less relevant information.     

When It's Not The Only Game in Town: The Effect of Bilateral Search on the Quality of a Dealer Market

We report results from experimental asset markets with liquidity traders and an insider where we allow bilateral trade to take place, in addition to public trade with dealers. In the absence of the search alternative, dealer profits are large—unlike in models with risk-neutral, competitive dealers. However, when we allow traders to participate in the search market, dealer profits are close to zero. Dealers compete more aggressively with the alternative trading avenue than with each other. There is no evidence that price discovery is less efficient when the specialists are not the only game in town.     

Learning from others,reacting, and market quality

Traders pay attention to one another but are unable to perfectly deduce each others’ beliefs from transactions alone. This explains why markets are hard to beat and also why trading occurs at all. Even when traders react rationally to the actions of others, they cannot arrive easily at a common posterior assessment of value. We model a realistic market composed of traders who combine their own private information with rational learning about the information possessed by others. We compare phenomena in this market with an otherwise identical market populated by traders who receive the same private information but ignore other traders. Using simulation to engender greater realism, we find that learning usually reduces volatility, increases the accuracy of the market price as a forecast of value, reduces trading volume, and decreases the prevalence of bubbles. However, for some combinations of market conditions, learning can have the opposite effect. The marginal influences of eight different market conditions, ranging from information heterogeneity through resource diversity, are estimated. Prices, volatility, volume, and bubbles exhibit subtle and complex responses to market conditions.     

Who makes markets

A dealer needs access to order flow and information to make a market profitably in a Nasdaq stock. Several variables that proxy for the stocks that an individual market maker's brokerage customers trade, including volume, location, underwriting participation and analyst coverage, are significant determinants of market making activity. Informational advantages may also factor in the market making decision as evidenced by dealers specializing in industries. These findings suggest that individual dealers have competitive advantages in making markets in specific stocks, and that potential market making competition comes from the dealers who share those advantages rather than all Nasdaq market makers.     

The impact of competition and information on intraday trading

In a dynamic model of financial market trading multiple heterogeneously informed traders choose when to place orders. Better informed traders trade immediately, worse informed delay – even though they expect the market to move against them. This behavior generates intraday patterns with decreasing spreads, decreasing probability of informed trading (PIN), and increasing volume. We predict that policies that foster market entry improve the welfare of uninformed traders and lead to increased market participation by incumbent traders. Technological advances that lead to better signal processing also encourage market participation and increase volume but at the expense of uninformed traders’ welfare.     

Belief-free price formation

We analyze security price formation in a dynamic setting in which long-lived dealers repeatedly compete for the opportunity to trade with short-lived retail traders. We characterize equilibria in which dealers’ pricing strategies are optimal irrespective of the private information that each dealer may possess. Thus, our model’s predictions are robust to different specifications of the dealers’ information structure. These equilibria reconcile, in a unified and parsimonious framework, price dynamics that are reminiscent of well-known stylized facts: excess price volatility, price to trading flow correlation, stochastic volatility and inventory-related trading.     

VPIN,liquidity, and return volatility in the U.S. equity markets

We examine the volume-synchronized probability of informed trading metric (the VPIN flow toxicity metric, developed by Easley, Lopez de Prado, & O'Hara, 2012) as a real-time risk management tool for liquidity deteriorations in the U.S. equity markets. We find that VPIN provides information about market liquidity and stock return volatility on ex-ante basis. These results indicate that VPIN can be a useful risk-management tool for market makers, regulators and traders in the U.S. equity markets. We also document that VPIN is negatively associated with volume and number of trades, but positively associated with trade size and volume fragmentation. These findings suggest that VPIN indicates the adverse selection problem of liquidity providers by capturing the information in volume.     

The “make or take” decision in an electronic market: Evidence on the evolution of liquidity

This paper uses experimental asset markets to investigate the evolution of liquidity in an electronic limit order market. Our market setting includes salient features of electronic limit order markets, as well as informed traders and liquidity traders. We focus on the strategies of the traders and how these are affected by trader type, characteristics of the market, and characteristics of the asset. We find that informed traders use more limit orders than do liquidity traders. Our main result is that liquidity provision shifts as trading progresses, with informed traders increasingly providing liquidity in markets. The change in the behavior of the informed traders seems to be in response to the dynamic adjustment of prices to information; they take (provide) liquidity when the value of their information is high (low). Thus, a market-making role emerges endogenously in our electronic markets and is ultimately adopted by the traders who are least subject to adverse selection when placing limit orders.     

On the limits to speculation in centralized versus decentralized market regimes

Speculation creates an adverse selection cost for utility traders, who will choose not to trade if this cost exceeds the benefits of using the asset market. However, if they do not participate, the market collapses, since private information alone is not sufficient to create a motive for trade. There is, therefore, a limit to the number of speculative transactions that a given market can support. This paper compares this limit in decentralized, monopoly-intermediated and competitively-intermediated market regimes, finding that the second regime is best equipped to deal with speculation: an informed monopolist can price-discriminate investors and thus always avoid market breakdowns. These regimes are also compared in terms of welfare and trading volume. The analysis suggests a reason for the presence of intermediaries in financial markets.     

Market Statistics and Technical Analysis: The Role of Volume

We investigate the informational role of volume and its applicability for technical analysis. We develop a new equilibrium model in which aggregate supply is fixed and traders receive signals with differing quality. We show that volume provides information on information quality that cannot be deduced from the price statistic. We show how volume, information precision, and price movements relate, and demonstrate how sequences of volume and prices can be informative. We also show that traders who use information contained in market statistics do better than traders who do not. Technical analysis thus arises as a natural component of the agents' learning process.     

Benchmarks in Search Markets

We characterize the role of benchmarks in price transparency of over‐the‐counter markets. A benchmark can raise social surplus by increasing the volume of beneficial trade, facilitating more efficient matching between dealers and customers, and reducing search costs. Although the market transparency promoted by benchmarks reduces dealers' profit margins, dealers may nonetheless introduce a benchmark to encourage greater market participation by investors. Low‐cost dealers may also introduce a benchmark to increase their market share relative to high‐cost dealers. We construct a revelation mechanism that maximizes welfare subject to search frictions, and show conditions under which it coincides with announcing the benchmark.     

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.     

An empirical investigation of large trader market manipulation in derivatives markets

Using account-level transaction data in options and futures markets, we investigate the existence of market manipulation, which is the ability of large traders to trade strategically, impacting prices and making abnormal profits. First, large trader’s option positions have a quantity impact on the underlying asset’s price. Second, large traders generate significantly positive alphas from trading options and futures. Among the different investor types, proprietary dealers generate the largest positive alphas. Third, these abnormal returns are consistent with strategic trading and cross-market manipulation. The evidence supports market manipulation across the options and futures markets, but not within the futures market itself.     

Dealer behavior and trading systems in foreign exchange markets

We study dealer behavior in the foreign exchange spot market using detailed observations on all the transactions of four interbank dealers. There is strong support for an information effect in incoming trades. The direction of trade is most important, but we also find that the information effect increases with trade size in direct bilateral trades. All four dealers control their inventory intensively. Inventory control is not, however, manifested through a dealer's own prices in contrast to findings by Lyons (J. Financial Econ. 39(1995) 321). Furthermore, we document differences in trading styles, especially how they actually control their inventories.