The effectiveness of position limits: Evidence from the foreign exchange futures markets

This study considers the effects of the relative size of hedger and speculator open interests and the potential impact of implementing position limits on the price discovery process in both JPY–USD and EUR–USD futures markets. Hedging trading exerts a negative impact, regardless of its size, on price discovery in futures markets. Hedgers are less likely to be information motivated, so their trading uniformly delays the price discovery process. However, there is a positive and nonlinear impact of speculators’ trade size on price discovery, the contribution of which depends on the relative size of the speculative open interest. Contrary to conventional wisdom among regulators, speculative trading does not harm the market in terms of market efficiency; as long as the percentage of speculators’ open interest is below an endogenously determined threshold (approximately 20% for EUR–USD and 16.3% for JPY–USD), speculative trading even improves futures market efficiency.     

Local market makers, liquidity and market quality

We examine the role of geographically proximate (local) market makers in providing liquidity and improving the quality of a dealer market. Firms with active participation of local dealers enjoy lower quoted and effective spreads, as well as more informative prices. The beneficial effects from local market makers are not confined to a few “top” local dealers and they cannot be attributed to their participation in the firm's IPO syndicate or industry specialization. Further, we find that days with aggressive bidding from local market makers relative to their non-local counterparts are associated with significant positive abnormal returns, consistent with local market makers possessing information advantages. In summary, our results suggest that the information advantages of local market makers may be a contributing factor to the reduction in the cost of trading.     

Trading frequency and asset pricing on the London Stock Exchange: Evidence from a new price impact ratio

This study proposes a new price impact ratio as an alternative to the widely used Amihud’s (2002) Return-to-Volume ratio. We demonstrate that the new price impact ratio, which is deemed Return-to-Turnover ratio, has a number of appealing features. Using daily data from all stocks listed on the London Stock Exchange over the period 1991–2008, we provide overwhelming evidence that this ratio, while being unequivocal to construct and interpret, is also free of a size bias. More importantly, it encapsulates the stocks’ cross-sectional variability in trading frequency, a relatively neglected but possibly important determinant of stock returns given the recently observed trends in financial markets. Overall, our findings argue against the conventional wisdom that there is a simple direct link between trading costs and stock returns by strongly suggesting that it is the compound effect of trading frequency and transaction costs that matters for asset pricing, not each aspect in isolation.     

Price Discovery in Illiquid Markets: Do Financial Asset Prices Rise Faster Than They Fall?

We study price discovery in municipal bonds, an important OTC market. As in markets for consumer goods, prices “rise faster than they fall.” Round‐trip profits to dealers on retail trades increase in rising markets but do not decrease in falling markets. Further, effective half‐spreads increase or decrease more when movements in fundamentals favor dealers. Yield spreads relative to Treasuries also adjust with asymmetric speed in rising and falling markets. Finally, intraday price dispersion is asymmetric in rising and falling markets, as consumer search theory would predict.     

Predicting the bear stock market: Macroeconomic variables as leading indicators

This paper investigates whether macroeconomic variables can predict recessions in the stock market, i.e., bear markets. Series such as interest rate spreads, inflation rates, money stocks, aggregate output, unemployment rates, federal funds rates, federal government debt, and nominal exchange rates are evaluated. After using parametric and nonparametric approaches to identify recession periods in the stock market, we consider both in-sample and out-of-sample tests of the variables’ predictive ability. Empirical evidence from monthly data on the Standard & Poor’s S&P 500 price index suggests that among the macroeconomic variables we have evaluated, yield curve spreads and inflation rates are the most useful predictors of recessions in the US stock market, according to both in-sample and out-of-sample forecasting performance. Moreover, comparing the bear market prediction to the stock return predictability has shown that it is easier to predict bear markets using macroeconomic variables.     

Local investors,price discovery,and market efficiency

This study examines the effect of locally informed investors on market efficiency and stock prices using large power outages, which are exogenous events that constrain trading. Turnover in stocks headquartered in an outage area with 0.5% of U.S. electrical customers drops by 3–7% on the first full day of the outage, and bid–ask spreads narrow by 2.5%. Firm-specific price volatility is 2.3% lower on blackout dates. This effect is larger for smaller, lesser-known stocks and in higher income areas. Consistent with a valuation discount and higher expected returns for stocks with more informed traders, firms with a one-standard-deviation higher local trading propensity have market-to-book values that are 5% lower, Tobin's Q that is 6% lower, annualized four-factor alphas that are 1.2% higher, and average spreads that are 6.5% higher. Together, the evidence suggests that informed investors contribute disproportionately to both liquidity and price discovery, and that these contributions are reflected in valuations and expected returns.     

A market-clearing role for inefficiency on a limit order book

Limit order markets with stationary dynamics attract equal volumes of market orders and uncanceled limit orders, equalizing the supply and demand for liquidity and immediacy. To maintain this balance, market orders must share any benefit obtained by limit order traders from more efficient trading conditions, such as better order queuing policies. Therefore an efficient market places a low price on immediacy, producing small bid–ask spreads. Furthermore, when price-discreteness leads to a mainly constant spread, cutting the price tick raises surplus. This is modeled with a stochastic sequential game, using stationarity considerations to bypass direct analysis of traders’ intricate market forecasts.     

Price dispersion in OTC markets: A new measure of liquidity

In this paper, we model price dispersion effects in over-the-counter (OTC) markets to show that, in the presence of inventory risk for dealers and search costs for investors, traded prices may deviate from the expected market valuation of an asset. We interpret this deviation as a liquidity effect and develop a new liquidity measure quantifying the price dispersion in the context of the US corporate bond market. This market offers a unique opportunity to study liquidity effects since, from October 2004 onwards, all OTC transactions in this market have to be reported to a common database known as the Trade Reporting and Compliance Engine (TRACE). Furthermore, market-wide average price quotes are available from Markit Group Limited, a financial information provider. Thus, it is possible, for the first time, to directly observe deviations between transaction prices and the expected market valuation of securities. We quantify and analyze our new liquidity measure for this market and find significant price dispersion effects that cannot be simply captured by bid-ask spreads. We show that our new measure is indeed related to liquidity by regressing it on commonly-used liquidity proxies and find a strong relation between our proposed liquidity measure and bond characteristics, as well as trading activity variables. Furthermore, we evaluate the reliability of end-of-day marks that traders use to value their positions. Our evidence suggests that the price deviations from expected market valuations are significantly larger and more volatile than previously assumed. Overall, the results presented here improve our understanding of the drivers of liquidity and are important for many applications in OTC markets, in general.     

Automation, speed, and stock market quality: The NYSE's Hybrid

Automation and trading speed are increasingly important aspects of competition among financial markets. Yet we know little about how changing a market's automation and speed affects the cost of immediacy and price discovery, two key dimensions of market quality. At the end of 2006 the New York Stock Exchange introduced its Hybrid Market, increasing automation and reducing the execution time for market orders from 10 seconds to less than one second. We find that the change raises the cost of immediacy (bid-ask spreads) because of increased adverse selection and reduces the noise in prices, making prices more efficient.     

Ripples through markets: Inter-market impacts generated by large trades

This paper uses a sample of large trades executed on the London Stock Exchange's SEAQ-I market for European cross-traded firms to investigate their impact on home market prices when parallel markets suffer from information frictions. I find that (a) large London trades produce price impacts in home markets even though no timely information is published, (b) market makers appear to pre- and post-position their inventories by splitting orders across markets, and (c) the price discovery process across markets changes significantly around large trades with the foreign market making a significantly bigger contribution to price discovery at this time, even though information opaqueness exists.     

Competition without fungibility: Evidence from alternative market structures for derivatives

In this paper, we compare option contracts from a traditional derivatives exchange to bank-issued options, also referred to as covered warrants. While bank-issued option markets and traditional derivatives exchanges exhibit significant structural differences such as the absence of a central counterparty for bank-issued options, they frequently exist side-by-side, and the empirical evidence shows that there is significant overlap in their product offerings although options are not fungible between the two markets. The empirical analysis indicates that bid-ask spreads in either market are lowered by 1–2% due to competition from the other market, providing evidence that the benefits of competing market structures are available in the absence of fungibility.     

Strategic online banking adoption

In this paper we study the determinants of banks’ decisions to adopt a transactional website for their customers. Using a panel of commercial banks in the United States for the period 2003–2006, we show that although bank-specific characteristics are important determinants of banks’ adoption decisions, competition also plays a prominent role. The extent of competition is related to the geographic overlap of banks in different markets and their relative market share in terms of deposits. In particular, banks adopt online banking services earlier in markets where their competitors have already adopted this technology. This paper is one of the first to construct local banking markets using the geographic market definitions delimited by the CASSIDI® Database compiled at the Federal Reserve Bank of St. Louis.     

Control-ownership wedge and investment sensitivity to stock price

This study examines whether insiders’ incentives for private control benefits affect investment sensitivity to stock price. While Chen et al. (2007) link stock price informativeness to firms’ learning from the stock market, we offer an alternative agency-cost based explanation. Using a total of 2822 firms from 22 countries in East Asia and Western Europe, we document a strong negative association between control-ownership wedge and investment-q sensitivity, suggesting that insiders’ incentives for private control benefit reduce their propensity to listen to the market. Furthermore, the negative impact of wedge on investment-q sensitivity is primarily driven by sub-optimal investments. Overall, we provide evidence that agency problem is an important factor that determines the learning from the stock market in capital allocation.     

Locals, foreigners, and multi-market trading of equities: Intraday evidence from Thailand

We study stock market orders and trades in a developing country, Thailand, where foreign ownership limits partially segment local and foreign investors into two distinct markets. Some foreigners forgo voting rights and distributions to trade on the “local board”, while some locals forgo such benefits and pay a price premium to trade on the “foreign board”. Regardless of nationality, these cross-market traders typically submit orders when liquidity is high, fill orders at relatively beneficial prices, exploit patterns in stock prices across markets, display profitable holding-period returns, and enhance price discovery. This suggests that skilled, informed trading that affects market quality does not depend on trader nationality.     

Market structure and dealers’ quoting behavior in the foreign exchange market

This article examines how differently the same dealer quotes in the inter-dealer and customer foreign exchange markets that have different market structures. The model first predicts that customer spreads are generally wider than inter-dealer ones due to less transparency in the customer market. The model also predicts that since customers are believed to be less informed than dealers, the differential between customer and inter-dealer spreads tends to fall with the rise in order sizes. In addition, the dealer's mid-quotes are shown to be the same in the two markets. Empirical evidence based on data collected from a FX dealer supports these theoretical findings.     

The accuracy of the tick test: Evidence from the Australian stock exchange

In the absence of information regarding whether a trade is buyer or seller initiated, many researchers have employed the ‘tick’ rule as a proxy. These researchers have been supported in their endeavours by the work of Lee and Ready (1991) which suggests that the tick rule is 90% accurate. Unfortunately, the difficulty of securing data on this issue has made Lee and Ready's paper somewhat unique in that there have been few attempts to confirm their result in US markets and no attempts in other markets. The purpose of this work is to test the robustness of their result in the Australian securities market. Using cleaner intra-day data we mimic the Lee and Ready study to cast some doubt upon the robustness of their findings in different markets. Our results suggest an overall accuracy of approximately 74% as opposed to Lee and Ready's 90%. However, accuracy in excess of 90% is documented when zero ticks are excluded. Further analysis provides evidence that a volatile or trending market will decrease the accuracy of the tick rule. It is also demonstrated that the tick rule is less likely to accurately classify seller initiated trades and small buyer initiated trades.     

On the relationship between exchange rates and equity returns: A new approach

This paper employs a new approach in order to investigate the underlying relationship between stock markets and exchange rates. Current approaches suggest that the relative equity market performance of two countries is linked to their exchange rate. In contrast, this study proposes an alternative approach where one global variable – global equity market returns – is believed to have an effect on exchange rates, with the relative interest rate level of a currency determining the sign of the relationship. Our empirical findings suggest that exchange rates and global stock market returns are strongly linked. The value of currencies with higher interest rates is positively related with global equity returns, whereas the value of currencies with lower interest rates is negatively related with global equity returns.     

Specialists as risk managers: The competition between intermediated and non-intermediated markets

We develop a model that analyzes competition between a non-intermediated market (such as an electronic communications network) and an intermediated market (such as via the market specialist’s structure within the NYSE) when both markets are allowed to trade the same securities. Specialists are viewed as providers of a “volatility dampening” service, a mechanism for reducing round-trip trading costs, as well as an “order execution risk management” service. The economic value of these three specialist services is determined by five key factors (the difference in spreads between the two financial market types, investors’ holding periods, the specialist’s quoted spread in relation to the asset’s price, the relative probability of executing an order in the intermediated market, and the short-term risk-free rate).     

Liquidity, analysts, and institutional ownership

In this paper, we investigate the empirical relationship between institutional ownership, number of analysts following and stock market liquidity. We find that firms with larger number of financial analysts following have wider spreads, lower market quality index, and larger price impact of trades. However, we find that firms with higher institutional ownership have narrower spreads, higher market quality index, and smaller price impact of trades. In addition, we show that changes in our liquidity measures are significantly related to changes in institutional ownership over time. These results suggest that firms may alleviate information asymmetry and improve stock market liquidity by increasing institutional ownership. Our results are remarkably robust to different measures of liquidity and measures of information asymmetry.     

Microstructural dynamics in a foreign exchange electronic broking system

This paper explores the relationships between quotations, spreads and transactions in the Foreign Exchange market. Such interactions have been the subject of much work in markets such as the NYSE, but until now have gone unexamined in the FX market owing to a lack of data. Using a 7 hour, transactions-based data set we examine the determinants of both quote revisions and spreads. The results indicate that trades are a major factor in spread determination and quote revisions. Furthermore, there is evidence that the widely documented negative auto-correlation in quote returns is at least partially caused by the ‘thinness’ of this particular segment of the FX market.