An empirical examination of the impact of market microstructure changes on the determinants of option bid-ask spreads

This paper examines the determinants of bid-ask spreads in the Australian Options Market before and after it switched from a quote-driven floor-traded market to an order-driven screen-traded market. This study reports that both put and call option bid-ask spreads are positively related to the option's value, its remaining term-to-maturity, its absolute hedge ratio and the volatility of returns from the underlying asset and negatively related to the level of trading activity in that option series. The study also reports that spreads are generally less when market makers are obliged to maintain continuous quotes in the market. The paper also finds that following the change in trading regime, both call and put option spreads became more sensitive to the absolute value of the option's delta. This finding is consistent with previous theoretical and empirical work from equities markets that has suggested that a switch to an electronic trading regime results in an increase in the adverse selection component of the bid-ask spread. There is also some limited evidence that suggests that the switch to electronic trading resulted in call option spreads being less sensitive to the return volatility of the underlying asset but more sensitive to the option's price.     

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.     

Information transfer,microstmctures and intraday price return spikes

Previous research has identified overnight public information as the cause of higher opening returns and mean reversion in security markets. This paper tests this hypothesis by using an intervention and transfer function time series model to filter out the dynamic effects of an overnight information set on the opening, and subsequent, intraday AOI stock and SPI futures intraday price returns. A further research objective was to analyse the process by which information is transferred into prices and whether there is a differential impact across stock and futures markets. It was determined that the information contained in the overnight US stock market had: (i) a differential impact on the Australian stock and futures market, and (ii) after filtering out the impact of overnight information, a significant reversal tendency remained in both markets after opening. Further analysis supported the conclusion that price spikes at opening were not wholly related to overnight information. Other possible explanations, such as different trading mechanisms, did not provide a satisfactory explanation. Overall, it appears that the uncertainty participants face at the beginning of a trading session may induce a number of subtle market reactions (both rational and irrational), in markets with different microstmctures and trading clientele.     

Exchange-traded funds,persistence in tracking errors and information dissemination

We estimate tracking errors from 26 exchange-traded funds (ETFs) utilizing three different methods and test their relative performance using Jensen's model. We find that tracking errors are significantly different from zero and display persistence. Based on Jensen's alpha, risk adjusted returns are significantly inferior to benchmark returns for all ETFs with two exceptions at conventional significance levels revealing that passive investment strategy does not outperform market returns. We then examine the degree to which frequently used factors such as expense ratio, dividends, exchange rate and spreads of trading prices may be underlying sources of tracking errors causing this underperformance. We find that the change in the exchange rate is a significant source of tracking errors. Our serial correlation test, runs test and panel regression analysis reveal that Asian markets display relatively greater persistence and therefore are less efficient in disseminating information and noisier in filtering the information contained in returns.     

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.     

Trading location and equity returns: Evidence from US trading of British cross-listed firms

Our study examines market sentiment and the importance of trading location in British American Depository Receipts (ADRs) traded in the US. Perfect integration between UK markets and UK ADRs is ruled out given that UK ADRs exhibit an intraday, U-shaped volatility curve. Both a variance decomposition analysis and an EGARCH model show that UK ADR returns are driven more by US market returns than US-traded UK ETF returns. These results indicate the existence of US market sentiment for UK ADRs and that trading location influences pricing behavior.     

Volatility spreads and earnings announcement returns

Prior research documents that volatility spreads predict stock returns. If the trading activity of informed investors is an important driver of volatility spreads, then the predictability of stock returns should be more pronounced during major information events. This paper investigates whether the predictability of equity returns by volatility spreads is stronger during earnings announcements. Volatility spreads are measured by the implied volatility differences between pairs of strike price and expiration date matched put and call options and capture price pressures in the option market. During a two-day earnings announcement window, the abnormal returns to the quintile that includes stocks with relatively expensive call options is more than 1.5% greater than the abnormal returns to the quintile that includes stocks with relatively expensive put options. This result is robust after measuring volatility spreads in alternative ways and controlling for firm characteristics and lagged equity returns. The degree of announcement return predictability is stronger when volatility spreads are measured using more liquid options, the information environment is more asymmetric, and stock liquidity is low.     

Testing the Random Walk Behavior and Efficiency of the Gulf Stock Markets

Inferences drawn from tests of market efficiency are rendered imprecise in the presence of infrequent trading. As the observed index in thinly traded markets may not represent the true underlying index value, there is a systematic bias toward rejecting the efficient market hypothesis. For the three emerging Gulf markets examined in this paper, correction for infrequent trading significantly alters the results of market efficiency and random walk tests. The Beveridge–Nelson (1981) decomposition of index returns is done to estimate the underlying index.     

The calm after the storm: implied volatility and future stock index returns

This article explores the predictive power of five implied volatility indices for subsequent returns on the corresponding underlying stock indices from January 2000 through October 2013. Contrary to previous research, very low volatility levels appear to be followed by significantly positive average returns over the next 20, 40 or 60 trading days. Rolling trading simulations show that positive adjusted excess returns can be achieved when long positions in the stock indices are taken on days of very low implied volatility. This may be a hint that market inefficiencies exist in some markets, especially outside the USA. The excess returns measured against a buy and hold benchmark are significant for the German and Japanese market when tested with a bootstrap methodology. The results are robust against a broad spectrum of specifications.     

Informed trading in the options market surrounding data breaches

This study investigated whether there is informed trading that takes advantage of data breach events. By analyzing the transactions in the options market, we conjectured that there are two distinct informed trading patterns: one that begins approximately 4 months prior and another that begins 8–12 months before the corporate data breach announcements. This is supported by evidence of higher trading volume and open interest for put options, a higher put-to-call volume ratio, a higher put-to-call open interest ratio, and lower spreads prior to such announcements. We also examined the stock reactions following data breach announcements and found significantly negative cumulative abnormal returns of −0.35% within one day. Moreover, a cross-sectional analysis showed that put-call ratios have predictive power for stock returns. Finally, additional evidence, such as trading strategies in the stock and options markets, is provided.     

Arbitrage and deflators in illiquid markets

This paper presents a stochastic model for discrete-time trading in financial markets where trading costs are given by convex cost functions and portfolios are constrained by convex sets. The model does not assume the existence of a cash account/numeraire. In addition to classical frictionless markets and markets with transaction costs or bid–ask spreads, our framework covers markets with nonlinear illiquidity effects for large instantaneous trades. In the presence of nonlinearities, the classical notion of arbitrage turns out to have two equally meaningful generalizations, a marginal and a scalable one. We study their relations to state price deflators by analyzing two auxiliary market models describing the local and global behavior of the cost functions and constraints.     

Spanish Stock Returns: Where is the Weather Effect?

Psychological studies support the existence of an influence of weather on mood. Saunders (1993) and Hirshleifer and Shumway (2001) argue that the weather could affect the behaviour of market traders and, therefore, it should be reflected in the stock returns. This paper investigates the possible relation between weather and market index returns in the context of the Spanish market. In 1989, this market changed its open outcry trading system into a computerised and decentralised trading system. Therefore, it is possible to check the influence of weather variables (sunshine hours and humidity levels) on index returns in an open outcry trading system, and to compare it with a screen traded environment. The empirical evidence indicates that, independently of the trading system, there is no influence of weather on stock prices. Thus, these findings do not contest the notion of efficient markets.     

The Effect of Sequential Information Arrival on Asset Prices: An Experimental Study

A complete understanding of security markets requires a simultaneous explanation of price behavior, trading volume, portfolio composition (ie., asset allocation), and bid-ask spreads. In this paper, these variables are observed in a controlled setting—a computerized double auction market, similar to NASDAQ. Our laboratory allows experimental control of information arrival—whether simultaneously or sequentially received, and whether homogeneous or heterogeneous. We compare the price, volume, and share allocations of three market equilibrium models: telepathic rational expectations, which assumes that traders can read each others minds (strong-form market efficiency); ordinary rational expectations, which assumes traders can use (some) market price information, (a type of semi-strong form efficiency); and private information, where traders use no market information. We conclude 1) that stronger-form market models predict equilibrium prices better than weaker-form models, 2) that there were fewer misallocation forecasts in simultaneous information arrival (SIM) environments, 3) that trading volume was significantly higher in SIM environments, 4) and that bid-ask spreads widen significantly when traders are exposed to price uncertainty resulting from information heterogeneity.     

Pairs trading in the UK equity market: risk and return

In this paper, we provide the first comprehensive UK evidence on the profitability of the pairs trading strategy. Evidence suggests that the strategy performs well in crisis periods, so we control for both risk and liquidity to assess performance. To evaluate the effect of market frictions on the strategy, we use several estimates of transaction costs. We also present evidence on the performance of the strategy in different economic and market states. Our results show that pairs trading portfolios typically have little exposure to known equity risk factors such as market, size, value, momentum and reversal. However, a model controlling for risk and liquidity explains a far larger proportion of returns. Incorporating different assumptions about bid-ask spreads leads to reductions in performance estimates. When we allow for time-varying risk exposures, conditioned on the contemporaneous equity market return, risk-adjusted returns are generally not significantly different from zero.     

Hot money in disaggregated capital flows

We explore the possible existence and behavior of hot money in six categories of disaggregated bilateral capital flows (equity inflows, equity outflows, bond inflows, bond outflows, banking credit inflows, and banking credit outflows) for 12 emerging markets vis-à-vis the US from 1995 to 2012 and provides several new findings. First, we identify the existence of hot money in all six categories above and conclude that both gross inflows and gross outflows can be the sources of hot money. Second, hot money in equity inflows (outflows) engages in positive (negative) feedback trading regarding local stock market returns. Third, some categories of hot money have a temporary influence on local stock market returns while the others have a permanent influence, supporting the explanations of both price pressures and information advantage. Finally, local stock market returns in half of our sample countries, which have tightened capital controls during the late 2000s global financial crisis (GFC), are more affected by hot money than in the other half. Our findings confirm several popular conjectures of hot money, and endorse the use of capital controls to limit financial vulnerability in the run-up to and during the GFC.     

Using implied volatility on options to measure the relation between asset returns and variability

Prior research has documented that volatility in financial asset markets is most directly related to trading rather than calendar days, and that there is an inverse asymmetric relation between volatility and returns in both stocks and long-term bonds. We examine these relations in 37 futures options markets representing a wide variety of asset types. Using futures prices and implied volatilities from this extensive array of markets, we confirm that in all of them, save one, market volatility is more directly related to trading days. However, the nature of the association between implied volatility and underlying asset returns varies greatly across asset categories and across exchanges. Thus, we show that findings from equity markets apparently are not generalizable to other asset classes.     

动量交易策略及我国股票市场实证分析

动量交易策略指的是事先针对股票收益及交易量设定过滤规则,一旦股票收益或者股票收益和交易量同时满足过滤规则就买入或卖出股票的交易策略。动量交易策略的理论基础是行为金融学。国外投资者已经成功地在实践中应用了该策略。我国股票市场是否存在动量效应,还未形成统一的结论。在总结国内外学者研究方法的基础上,利用目前可用的数据,对我国股票市场在中期条件下动量交易策略的适用性进行了实证研究。但得出的结论并不支持存在动量效应。     

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.     

Order flow, bid-ask spread and trading density in foreign exchange markets

This paper examines the implications of market microstructure for foreign exchange markets. We argue that the usual order flow model needs to be recast in broader terms to incorporate the transaction costs of liquidity and the limitation of price discovery through order flows that involve low trading density currencies. Using a daily data set, we find that order flows are inadequate when it comes to explaining the changes in the low trading density currencies. Alternatively, within the high trading density, both order flows and bid-ask spreads significantly affect the foreign exchange rate returns. Our findings suggest that the order flow model is better at incorporating these microstructure effects except for some currencies with a very high level of trading density.     

Return spread and liquidity: Evidence from Hong Kong ADRs

Fifteen Chinese H-shares listed on the Stock Exchange of Hong Kong are cross listed as ADRs on the NYSE. We empirically determine the role of security specific liquidity associated with those ADRs and their underlying H-shares on return spreads, differences between the returns on ADRs and their corresponding H-shares after controlling for ADRs and H-shares excess market returns and their respective price inverses denoting conditional betas. We use three proxies for liquidity, trading volume, turnover, and illiquidity (Amihud, 2002) and find that only trading volume and turnover are consistent determinants of return spread for the majority of Chinese ADRs with primary listing in Hong Kong Stock Exchange (SEHK). We use a switching regression model and find that the model parameter estimates are not stationary and change, often drastically between pre and post 2000 and 2003. Further tests using Bai Perron indicate return spreads data as non-stationary with multiple regime changes during the sample period. Further the causes of non-stationarity seem to be largely security specific and not driven by broad market swings in either market.