Slow-moving capital and execution costs: Evidence from a major trading glitch

We investigate the impact of an exogenous trading glitch at a high-frequency market-making firm on standard measures of stock liquidity (spreads, price impact, turnover, and depth) and institutional trading costs (implementation shortfall and volume-weighted average price slippage). Stocks in which the firm accumulates large long (short) positions increase (decrease) by about 4% during the glitch and become substantially more illiquid. It takes one day for prices and spread-based liquidity measures to revert. Institutional trading costs, however, remain significantly higher for more than one week. Both liquidity measures are also weakly correlated outside the glitch period, suggesting they capture different aspects of liquidity.     

Market Making Contracts,Firm Value,and the IPO Decision

We examine the effects of secondary market liquidity on firm value and the IPO decision. Competitive aftermarket liquidity provision is associated with reduced welfare and a discounted secondary market price that can dissuade IPOs. The competitive market fails in particular for firms or at times when uncertainty regarding fundamental value and asymmetric information are large in combination. In these cases, firm value and welfare are improved by a contract where the firm engages a designated market maker to enhance liquidity. Such contracts represent a market solution to a market imperfection, particularly for small, growth firms.     

A liquidity-based model for asset price bubbles

We provide a new liquidity-based model for financial asset price bubbles that explains bubble formation and bubble bursting. The martingale approach to modeling price bubbles assumes that the asset's market price process is exogenous and the fundamental price, the expected future cash flows under a martingale measure, is endogenous. In contrast, we define the asset's fundamental price process exogenously and asset price bubbles are endogenously determined by market trading activity. This enables us to generate a model that explains both bubble formation and bubble bursting. In our model, the quantity impact of trading activity on the fundamental price process—liquidity risk—is what generates price bubbles. We study the conditions under which asset price bubbles are consistent with no arbitrage opportunities and we relate our definition of the fundamental price process to the classical definition.     

Glamour among value: P/E ratios and value investor attention

The trailing-four-quarter price–earnings (P/E) ratio is the most popular fundamental value proxy. This article is the first to examine the P/E ratio as the preeminent measure of value investor attention. Trailing-four-quarter P/E ratios predict significantly greater cross-sectional variation in stock returns than lagged P/E ratios or current price-to-book (P/B) ratios. P/E strategy returns are robust to variables that proxy for fundamental risk, variables mechanically related to P/E ratios, relative trading volume, and liquidity. The role of attention is evident in return patterns across long and short portfolios, day of the week, and time since formation. Stocks with low P/E ratios exhibit an increase in total trading volume driven by small trades, an improvement in liquidity, and lower idiosyncratic volatility. These patterns are consistent with the typical trading activity of individual investors, who have the strongest attention constraints.     

Price Informativeness and Investment Sensitivity to Stock Price

The article shows that two measures of the amount of privateinformation in stock price—price nonsynchronicity andprobability of informed trading (PIN)—have a strong positiveeffect on the sensitivity of corporate investment to stock price.Moreover, the effect is robust to the inclusion of controlsfor managerial information and for other information-relatedvariables. The results suggest that firm managers learn fromthe private information in stock price about their own firms’fundamentals and incorporate this information in the corporateinvestment decisions. We relate our findings to an alternativeexplanation for the investment-to-price sensitivity, namelythat it is generated by capital constraints, and show that boththe learning channel and the alternative channel contributeto this sensitivity. (JEL G14, G31)     

The High-Volume Return Premium

The idea that extreme trading activity contains information about the future evolution of stock prices is investigated. We find that stocks experiencing unusually high (low) trading volume over a day or a week tend to appreciate (depreciate) over the course of the following month. We argue that this high-volume return premium is consistent with the idea that shocks in the trading activity of a stock affect its visibility, and in turn the subsequent demand and price for that stock. Return autocorrelations, firm announcements, market risk, and liquidity do not seem to explain our results.     

Analysts’ sale and distribution of non fundamental information

We examine an analyst’s sale and distribution of information related to short-term price movements but unrelated to underlying firm value. By selling non fundamental information, the analyst increases competition on the signal, but prices become more sensitive to net order flow, creating an offsetting increase in the non fundamental signal’s value. More precise non fundamental information is more widely distributed. In the limit, a perfect non fundamental signal will be publicly disclosed for an arbitrarily small fee, and the analyst earns profits as if he possessed fundamental information. Consistent with empirical findings, analysts’ recommendations can be profitable, even when widely distributed or seemingly inconsistent with detailed forecasts. Analysis based on non fundamental information does not contribute to greater price efficiency but reduces liquidity costs. In a multi-period setting, traders with non fundamental information do not front-run, preferring to transact only in the period in which uninformed demand is executed.     

Liquidity distribution in the limit order book on the stock exchange of Thailand

The liquidity distribution, or the shape of the limit order book, influences trading behavior and choice of order submission by public liquidity suppliers. The present study seeks to discover whether liquidity providers are concerned about being picked off by informed traders, and whether they are less willing to supply liquidity at the market or demand higher price spreads. The results show that liquidity at the market is a small portion of total liquidity, and that firm size, minimum tick size, volatility, and trading volume play significant roles in determining the liquidity distribution within an order book.     

Giving Content to Investor Sentiment: The Role of Media in the Stock Market

I quantitatively measure the interactions between the media and the stock market using daily content from a popular Wall Street Journal column. I find that high media pessimism predicts downward pressure on market prices followed by a reversion to fundamentals, and unusually high or low pessimism predicts high market trading volume. These and similar results are consistent with theoretical models of noise and liquidity traders, and are inconsistent with theories of media content as a proxy for new information about fundamental asset values, as a proxy for market volatility, or as a sideshow with no relationship to asset markets.     

Endogenous informed trading in the presence of trading costs: Theory and evidence

The basic premise of the model we propose is that market frictions (trading costs) force traders with market-wide information to strategically choose which securities to trade in. We study the effect of recognizing trading costs on the choices of informed traders and the resulting statistical properties of security prices. Specifically, we show that (1) stocks with intermediate β's have the least informative prices, even though they are traded by the greatest number of informed traders; (2) for high β securities, the contemporaneous correlation of prices is close to the correlation in fundamental values; (3) a security with a higher β, higher volume of liquidity trading and lower idiosyncratic variance is more likely to lead another security. With market capitalization as a proxy for the level of liquidity trading, these specific predictions of the model on the lead–lag relationship are also shown to be strongly supported by the data.     

A Structured Financial Statement Analysis and the Direct Prediction of Stock Prices in Korea

Using a large sample of firms listed on the Korea Stock Exchange, this paper evaluates the usefulness of a structured, programmable financial statement analysis for investment decisions. In doing so, we develop a firm valuation model which links a firm's market value with fundamental variables such as the ability of a firm to generate cash flows, growth potentials, and risk. We predict a firm's intrinsic value directly from an extensive set of financial statement variables which proxy for the theoretical variables implied by the model. We then construct a series of trading strategies with zero net investment (called D-strategies) on the basis of D-values which measure percentage differences between predicted intrinsic values and observed market values. We observe that the market-adjusted and size-adjusted (hedge-portfolio) returns to the most conservative D-strategy turn out to be in the order of 16.92% and 11.44%, respectively,for the 12-month holding period. When our sample is stratified into two sub-samples based on firm size, the D-strategy yields higher excess return for the small-firm sub-sample than for the large-firm sub-sample. The above evidence, taken as a whole, strongly indicates that one can construct a profitable trading strategy by directly predicting intrinsic values through a structured financial statement analysis such as ours.     

Cross-listing and subsequent delisting in foreign markets

Employing a sample of stocks cross-listed and subsequently delisted from foreign markets, we examine the consequences of delisting to investors in terms of price, risk, and liquidity. We also provide a direct comparison between the firm's performance after a foreign cross-listing and after its subsequent delisting. We find a positive cross-listing and negative delisting effect on stock price, both of which dissipate in the long run. No significant changes in the market risk are found for either event. Foreign cross-listing and delisting are associated with increasing and decreasing long term trading volume respectively. Further analysis reveals that firms delist in response to low host market return and low firm trading volume in the host market. The changes in liquidity and market risk from delisting relate those from cross-listing. Finally, our results show that the bonding hypothesis fails to explain the listing premium and the delisting loss.     

Valuation effects of investor relations investments

We investigate the stock price performance of 146 firms announcing the appointment of a new investor relations (IR) officer or the hiring of an IR firm between 1999 and 2005. We find positive abnormal returns around the announcement day. In addition, we find evidence that firms with lower valuations, higher idiosyncratic risk, greater chief executive officer holdings, and firms that announce in the post‐Sarbanes‐Oxley Act era experience greater valuation effects. Finally, we document significant reductions in the information asymmetry and significant increases in the liquidity and visibility of IR firms in the year following the IR announcement.     

Investor Conferences,Firm Visibility,and Stock Liquidity

We examine the influence of investor conferences on firms’ stock liquidity. We find that firms participating in conferences experience a 1.4% to 2.8% increase in stock liquidity compared to nonconference firms. Consistent with investor conferences improving firm visibility, the increase in liquidity is larger for firms with low pre‐conference visibility and varies predictably with conference characteristics that affect the ability of investors to revise their beliefs about the firm. However, for firms with a large investor base and high visibility, conference participation is associated with a decline in stock liquidity, consistent with investor conferences exacerbating the information asymmetry among investors.     

The value of information in cross-listing

Until 2004, the London Stock Exchange allowed firms to be traded in the specialized SEAQ-I platform without the firm's involvement. Trading only required an application by one LSE trading member firm. Such an institutional arrangement, which made cross-listings possible without a firms' approval, allows for a direct test of different theories of foreign listing. In particular, we can differentiate between market segmentation and liquidity hypotheses, which rely on a firm trading in a foreign exchange and informational hypotheses, which assume that a firm makes the decision to trade in a foreign exchange. We identify a sample of international firms that are admitted to trading on London's SEAQ-I platform without their involvement. We estimate the valuation effects of this multi-market trading event and compare them to those enjoyed by firms that pursue a standard London Stock Exchange cross-listing. A cross-sectional abnormal returns analysis documents significant evidence in support of information-related hypotheses of cross-listing. An analysis of the firms' home market price volatility corroborates the results.     

Understanding short-term price pressure from index reconstitutions: Evidence from the CSI 300

Motivated by the mixed results of the few prior studies, we focus on the short-term price performance of stocks added to or deleted from the CSI 300 Index. Consistent with the price pressure hypothesis, we evidence a temporary change in the prices of respective added and deleted stocks, followed by subsequent price reversions. To reconcile past studies, we also test several explanatory factors as potential sources of short-term price pressure. Results show that changes in investor trading behaviour, investor awareness, firm risk, and liquidity explain the short-term price pressure of added and deleted stocks, while changes in institutional trading, realised volatility, and liquidity explain the differences in the impact of reconstitutions between added and deleted stocks.     

Option market making under inventory risk

We propose a mean-variance framework to analyze the optimal quoting policy of an option market maker. The market maker’s profits come from the bid-ask spreads received over the course of a trading day, while the risk comes from uncertainty in the value of his portfolio, or inventory. Within this framework, we study the impact of liquidity and market incompleteness on the optimal bid and ask prices of the option. First, we consider a market maker in a complete market, where continuous trading in a perfectly liquid underlying stock is allowed. In this setting, the market maker may remove all risk by Delta hedging, and the optimal quotes will depend on the option’s liquidity, but not on the inventory. Second, we model a market maker who may not trade continuously in the underlying stock, but rather sets bid and ask quotes in the option and this illiquid stock. We find that the optimal stock and option quotes depend on the relative liquidity of both instruments as well as on the net Delta of the inventory. Third, we consider an incomplete market with residual risks due to stochastic volatility and large overnight moves in the stock price. In this setting, the optimal quotes depend on the liquidity of the option and on the net Vega and Gamma of the inventory.      

The high volume return premium: Cross-country evidence

We examine the high volume return premium across 41 different countries and find it to be a phenomenon found in both developed and emerging markets. The premium is not caused by systematic differences in risk or liquidity. Using Merton's (1987) investor recognition hypothesis as a guide, we find the magnitude of the premium is generally associated with country and firm characteristics hypothesized to affect returns subsequent to a change in a stock's visibility. We also characterize the time-series properties of the premium and consider economic trading strategies.     

Optimal commodity asset allocation with a coherent market risk modeling

This paper fills a fundamental gap in commodity price risk management and optimal portfolio selection literatures by contributing a thorough reflection on trading risk modeling with a dynamic asset allocation process and under the supposition of illiquid and adverse market settings. This paper analyzes, from a portfolio managers' perspective, the performance of liquidity adjusted risk modeling in obtaining efficient and coherent investable commodity portfolios under normal and adverse market conditions. As such, the author argues that liquidity risk associated with the uncertainty of liquidating multiple commodity assets over given holding periods is a key factor in formalizing and measuring overall trading risk and is thus an important component to model, particularly in the wake of the repercussions of the recent 2008 financial crisis. To this end, this article proposes a practical technique for the quantification of liquidity trading risk for large portfolios that consist of multiple commodity assets and whereby the holding periods are adjusted according to the specific needs of each trading portfolio. Specifically, the paper proposes a robust technique to commodity optimal portfolio selection, in a liquidity-adjusted value-at-risk (L-VaR) framework, and particularly from the perspective of large portfolios that have both long and short positions or portfolios that consist of merely pure long trading positions. Moreover, in this paper, the author develops a portfolio selection model and an optimization-algorithm which allocates commodity assets by minimizing the L-VaR subject to applying credible operational and financial constraints based on fundamental asset management considerations. The empirical optimization results indicate that this alternate L-VaR technique can be regarded as a robust portfolio management tool and can have many uses and applications in real-world asset management practices and predominantly for fund managers with large commodity portfolios.     

Interbank market liquidity and central bank intervention

We develop a simple model of the interbank market where banks trade a long term, safe asset. When there is a lack of opportunities for banks to hedge idiosyncratic and aggregate liquidity shocks, the interbank market is characterized by excessive price volatility. In such a situation, a central bank can implement the constrained efficient allocation by using open market operations to fix the short term interest rate. It can be constrained efficient for banks to hoard liquidity and stop trading with each other if there is sufficient uncertainty about aggregate liquidity demand compared to idiosyncratic liquidity demand.