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Knowing me, knowing you:: Trader anonymity and informed trading in parallel markets
Abstract
In this paper we empirically analyze whether the degree of trader anonymity is related to the probability of information-based trading. We use data from the German stock market where non-anonymous traditional floor based exchanges co-exist with an anonymous computerized trading system. We use an extended version of the Easley et al. (J. Finance 51 (1996) 1405) model that allows for simultaneous estimation for two parallel markets. We find that the probability of informed trading is significantly lower in the floor based trading system. We further document that the size of the spread and the adverse selection component are positively related to the estimated probabilities of information-based trading.
... Foucault et al. (2007) show that anonymity improves liquidity when the fraction of informed trading is small. Grammig et al. (2001) empirically test stocks that are simultaneously traded at both the floor trading system and anonymous electronic cross-network on the Frankfurt Stock Exchange and find that the non-anonymous floor trading system has less informed trading than the anonymous electronic market. ...
... The empirical evidence points towards a different conclusion. Grammig et al. (2001) examine the relationship between anonymity and informed trading in the German stock market, and show how anonymity attracts informed trading. In contrast, Jiang et al. (2012) investigate the information quality of the order flow in lit-and off-exchanges and find that the order flow executed in off-exchanges is less informed than in lit-exchanges. ...
This paper reviews the up-to-date theoretical, empirical, and experimental literature related to the trading venue choice in the context of the fragmented equity markets. We provide a brief background on the history of trading fragmentation in the equity market and its determinants. We discuss the direct and indirect impacts of the market fragmentation on market quality in various dimensions, including liquidity, volatility, and price efficiency. Next, we identify possible determinants and channels from theoretical and empirical studies that could explain order routing decisions and present the possible directions for future research. Finally, we discuss the major regulatory reforms in the U.S. equity market on routing venue decisions. This topic is relevant in current times when phenomena such as “GameStop Frenzy” have drawn significant attention to commission-free trading venues.
... where absspread t is the absolute spread at time t , At p is the lowest ask price and Bt p is the highest bid price. Many authors, including with Chordia, et al. [10], Ranaldo [19], Grammig, et al., [20] Amihud, et al., [21] and Chiyachantana, et al. [22] showcase the use of absolute (quoted) spread and as a proxy for market liquidity. For instance, Chordia, et. ...
... al., [23] used absolute spread and effective spread measure in their study of liquidity and trading activity for a comprehensive sample of NYSE-listed stocks over an 11-year period. Similarly Grammig,et al.,[20] use data from the German stock market and estimates the probability of informed trading for stocks that are simultaneously traded in a nonanonymous floor trading system and in an anonymous electronic auction market. ...
This study investigates the nexus between the market tightness and economic growth in Kenya using data from 2006-2015 from Nairobi Security Exchange and Kenya National Bureau of Statistics. A parsimonious moderating regression analysis (MRA) has been presented to examine whether real interest rate and risk premium individually moderates the relationship between stock market tightness (proxied by various versions of spread) and the economic growth (proxied by Real Gross Domestic Product (GDP)) in Kenya. The study shows that both real interest rates and risk premium moderates the relationship between stock market tightness and the economic growth in Kenya.
... Our paper is also related to a stream of literature which examines adverse selection and informed trading across electronic markets. Grammig et al. (2001) and Barclay et al. (2003) demonstrate that order flow in electronic markets tends to be more informative, presumably because informed traders value the higher speed and low cost offered by these venues. ...
... where Vk and Vj denote the pound volumes traded on markets k and j respectively, Vj represents the total pound volume traded in all markets, and j j k V V is the market share of market k among those markets. 5 Furthermore, we also test the degree of off-exchange fragmentation since some studies suggest that high-tech entrant markets generate more informed order flows (see for example Grammig et al., 2001;Barclay et al., 2003). This proxy illustrates visible fragmentation by calculating how much volume is traded via off-exchange venues, i.e. the other three venues in the sample other than the LSE. ...
... Further topics have been the informativeness of trade size to market participants (Easley et al. 1997b), the effect of analyst coverage on a stock's share of information-based trading (Easley et al. 1998) and the use of limit orders and the effect of stock splits on information asymmetry (Easley et al. 2001). Estimations of PIN have been used as indicator of market quality to compare different trading venues and evaluate market design (changes), as Heidle and Huang (2002) do for NASDAQ versus NYSE, Grammig et al. (2001) for electronic versus floor trading or Hachmeister and Schiereck (2010) for post-trade anonymity-and the list of empirical applications of PIN could easily be extended. 1 However, results in current empirical literature also spell doubt on the PIN model's validity. ...
This paper develops a new intraday estimation procedure for the sequential microstructure trading model initially proposed by Easley et al. (Rev Financ Stud 10:805–835, 1997a). Using a full year of intraday trading data for the top 100 German stocks, we demonstrate how the new estimation procedure eliminates or significantly reduces the shortcomings of the original approach in recent, high-frequency trading environments. We slice a trading day in buckets of several minutes’ length to obtain one estimate of the composite variable probability of informed trading (PIN) per day. This approach makes PIN applicable in short horizon event studies. Convergence rates are above 95 % even for the most liquid stocks and the model’s underlying assumptions of independence for the arrival of traders and information events are fulfilled to a much higher degree than in the original approach. An empirical application in an event study type setting demonstrates how official announcements stipulated in German insider trading legislation significantly reduce information asymmetry upon public disclosure.
... 3. Effects on alternative measures of market quality as depth, volume, or probability of information-based trading have been also studied in the literature. See, for instance, Foucault et al. (2007), Frino et al. (2008), and Grammig et al. (2001). 4. Naes and Skjeltorp (2006) or Martínez et al. (2005) among others, using information of the consolidated LOB build some style measure that shows the properties of liquidity measured beyond the quoted spreads. ...
This paper analyses the effects on liquidity of voluntary pre-trade anonymity in the trading process. We confirm previous studies showing that market liquidity improves immediately after anonymous trading. Using the daily percentage of effective volume traded anonymously, we show that the anonymity–liquidity relationship presents a non-linear U-shape. We focus on the voluntary concealment of broker identification introduced by the Spanish Stock Exchange in October 2015. We conclude that, in our sample, anonymity increases stock liquidity but at a decreasing rate; when a considerable part of the effective volume is traded anonymously, additional percentages of anonymous trading deteriorates stock liquidity.
... This measure has been widely used in many knowledge fields. For example, PIN has been present on papers involving stock split (Easley et al., 2001); on the role of anonymity in the negotiation process (Grammig et al., 2001); on the relation between information risk and expected returns of financial assets (Easley et al., 2002(Easley et al., , 2010, among others. ...
... This measure has been widely used in many knowledge fields. For example, PIN has been present on papers involving stock split (Easley et al., 2001); on the role of anonymity in the negotiation process (Grammig et al., 2001); on the relation between information risk and expected returns of financial assets (Easley et al., 2002(Easley et al., , 2010, among others. ...
... Turnover and market depth focus on the total trading amount and the total volume of bid and ask volume (Brockman et al. (2000)). Bid and ask spread is frequently used as the indicator to reflect liquidity conditions (Chordia et al. (2001) and Grammig et al. (2001)). There are other liquidity measures concentrating on spread studied by (Hamao and Hasbrouck (1995), Levin et al. (1999), Fleming and Remolona (1999), Seppi (2001), Genccay et al. (2001), and Ranaldo (2008)). ...
Liquidity describes the degree to which an asset or security can be quickly bought or sold in the market without affecting the asset's price. In this study, some of the existing liquidity measures are studied and analyzed during Brexit. We examine Utilities Select Sector SPDR Fund (Exchange-Traded Fund) components in this study. The time period covers June 16, 2016 to June 30, 2016 which includes Brexit event day. We use high-frequency tick level Trade data, Quote data, and Limit Order Book data.We study the sample of Trade and Quote liquidity measures (TAQL) and Limit Order Book liquidity measures (LOBL). Our study shows that the correlations be-tween these two liquidity groups (TAQL & LOBL) have significant relationship with the returns of the underlying ETF components. Furthermore, the analysis shows that low correlation between TAQL and LOBL indicates high probability of large price change. Finally, we study the empirical distributions, which implies that Brexit generated fatter tails on liquidity measures distributions. This indicates that infrequent (low) liquidity condition occurs more frequently during Brexit.
... If named quotations are indeed more informative, I should observe that they tend to be asso-3 Röell (1990), Fishman and Longstaff (1992), Forster and George (1992) and Foucault, Moinas, and Theissen (2007) among others. 4 The literature provides mixed empirical results on the usage of anonymity by traders in the market, e.g., (Barclay, Hendershott, and McCormick, 2003;Grammig, Schiereck, and Theissen, 2001;Goldstein, Shkilko, Van Ness, and Van Ness, 2008;Perotti and Rindi, 2006;Reiss and Werner, 2005). The mixed results can be explained based on fundamental differences in market design, and accessibility across different trading systems. ...
This research investigates dealers' motivation to disclose their names when quoting on the NASDAQ over the years. NASDAQ enables dealers to quote limit orders either anonymously or with a feature that reveals their names. Results are consistent with dealers advertising by revealing their identities so as to develop and maintain their reputation for reliable pricing. Dealers strategically choose to reveal their identities when order flow is profitable. Post-name disclosure analysis further suggests that named quotations are likely to be driven by informational considerations. This research contributes to our understanding of the use of non-anonymity in electronic trading.
... Finally, these studies also find that large number of trades executed in the upstairs market offer price improvements, which is consistent with Grossman (1992) who argues that upstairs dealers are able to provide price improvements when they have information about customers' unexpressed demands. Additionally, Grammig et al. (2001) find similar evidence in the German stock market, where an anonymous electronic limit order book competed with the Frankfurt Stock Exchange, which operated a floor suggest that larger trades are more likely to be executed upstairs where they have a lower price impact, and an order of a given size is more likely to be traded upstairs if the primary venue is illiquid (higher spread and lower depth). Finally, the authors observe that there is an inverse relationship between price volatility and off-market trading. ...
Technological advances and regulatory initiatives have led to the emergence of a competitive, but fragmented, equity trading landscape in several markets around the world. While these changes have coincided with benefits like reduced transaction costs, advancements in trading technology, and access to a diverse array of execution venues, regulators and market participants have also raised concerns about the welfare implications of innovations like dark pools as well as the resulting increase in execution complexity. Exchanges are often viewed as natural monopolies due to the presence of network externalities and economies of scale. However, heterogeneity in traders' preferences means that no single venue can serve the interests of all investors. Fragmentation of the marketplace can be seen as a direct outcome of this heterogeneity. In this paper, we review the theoretical and empirical literature examining the economic arguments and motivations underlying market fragmentation, the resulting implications for liquidity and price efficiency, and the role for public policy. Beyond the concerns for equity markets, the lessons from this literature are relevant for other asset classes experiencing an increase in competition between trading venues.
... Demsetz (1968) initiated empirical research on bid-ask spreads and many studies follow from this ground-breaking work. For example, Chordia et al. (2001) and Corwin (1999) study stocks traded in the New York Stock Exchange, Christie and Schultz (1994) and Barclay et al. (1999) examine the NASDAQ and Grammig et al. (2001) study stocks in the German market. Meanwhile, Acker et al. (2002) analyze the behavior of bid-ask spreads around corporate earnings announcement dates and Harris et al. (2002) explore price discovery mechanisms by comparing trading patterns in different stock exchanges. ...
In this article, we consider how different dimensions of liquidity have been measured in financial markets and for various forms of real estate investment. The purpose of this exercise is to establish the range of liquidity measures that could be used for real estate investments before considering which measures and questions have been investigated so far. Most measures reviewed here are applicable to public real estate, but not all can be applied to private real estate assets or funds. Use of a broader range of liquidity measures could help real estate researchers tackle issues such as quantification of illiquidity premia for the real estate asset class or different types of real estate, and how liquidity differences might be incorporated into portfolio allocation models.
... In regards to the Brazilian market, anonymity should be greater in the futures market since noisy trading in high liquid markets should help to obscure informed trading. In a study of the German stock market, Grammig et al. (2001) found that the probability of informed trading is significantly lower in environments with lower degrees of anonymity. The spot market's highly decentralized environment also does not favor the transaction execution motivation. ...
We study price discovery in the Brazilian Foreign Exchange (FX) markets and indicate which market (spot or futures) adjusts more quickly to the arrival of new information. We find that futures market dominates price discovery since it responds for 66.2% of the variation in the fundamental price shock and for 97.4% of the fundamental price composition, corroborating the result provided in previous studies that, in a unique world example, the exchange rate is formed in the futures market. In a dynamic perspective, the futures market is also more efficient since, when markets are subjected to a shock in the fundamental price, it is faster to recover to equilibrium. By computing price discovery according to calendar semesters, we find evidence of the correlation between price discovery metrics and market factors, such as spot market supply-demand disequilibrium, central bank interventions and institutional investors’ pressure.
... Demsetz (1968) initiates empirical research on bid-ask spreads and many studies follow from this ground-breaking work. For example, Chordia et al. (2001) and Corwin (1999) study stocks traded in the New York Stock Exchange, Christie and Schultz (1994) and Barclay et al. (1999) examine the NASDAQ and Grammig et al. (2001) study stocks in the German market. Meanwhile, Acker et al. (2002) analyze the behavior of bid-ask spreads around corporate earnings announcement dates while Harris et al. (2002) explore price discovery mechanisms by comparing trading patterns in different stock exchanges. ...
Liquidity is a fundamentally important facet of investments, but there is no single measure that quantifies it perfectly. Instead, a range of measures are necessary to capture different dimensions of liquidity such as the breadth and depth of markets, the costs of transacting, the speed with which transactions can occur and the resilience of prices to trading activity. This article considers how different dimensions have been measured in financial markets and for various forms of real estate investment. The purpose of this exercise is to establish the range of liquidity measures that could be used for real estate investments before considering which measures and questions have been investigated so far. Most measures reviewed here are applicable to public real estate, but not all can be applied to private real estate assets or funds. Use of a broader range of liquidity measures could help real estate researchers tackle issues such as quantification of illiquidity premiums for the real estate asset class or different types of real estate, and how liquidity differences might be incorporated into portfolio allocation
models.
... They argue that uninformed traders will take into consideration the trading history in placing their orders. Other researchers (see Brockman and Chung [5], such as Grammig et al. [6]) have also conducted studies on this topic. ...
Information is one of the important factors that influence the behavior of investors and then have an effect on the price of the risky assets in the market. Firstly, the new procedure developed by Easley et al. (2011) is used to estimate the Volume-Synchronized Probability of Informed Trading (VPIN) of the Chinese stock index futures market. Then VPIN for special scenarios is depicted. As a result, we find that the future contracts generally have a larger number of information transactions. We also find that, for particular scenarios, the probability of informed trading in the market has obvious exceptions. The larger proportion of informed trader is, the higher the volatility of the price is.
... WITH Q-METHOD This study develops the Q-Method, which aims at both PIN Model and extended PIN Models such as [16] and [17]. The PIN estimation procedure proposed by Easley et al. in [1] and [2] (theE-Method) does not consider the misclassification of trades and is a special case of Q-Method. ...
... Further topics have been the informativeness of trade size to market participants (Easley et al. 1997b), the effect of analyst coverage on a stock's share of information-based trading (Easley et al. 1998) and the use of limit orders and the effect of stock splits on information asymmetry (Easley et al. 2001). Estimations of PIN have been used as indicator of market quality to compare different trading venues and evaluate market design (changes), as Heidle and Huang (2002) do for NASDAQ versus NYSE, Grammig et al. (2001) for electronic versus floor trading or Hachmeister and Schiereck (2010) for post-trade anonymity-and the list of empirical applications of PIN could easily be extended. 1 However, results in current empirical literature also spell doubt on the PIN model's validity. ...
This paper develops a new intraday estimation procedure for the sequential microstructure trading model initially proposed by Easley et al. (Rev Financ Stud 10:805–835, 1997a). Using a full year of intraday trading data for the top 100 German stocks, we demonstrate how the new estimation procedure eliminates or significantly reduces the shortcomings of the original approach in recent, high-frequency trading environments. We slice a trading day in buckets of several minutes’ length to obtain one estimate of the composite variable probability of informed trading (PIN) per day. This approach makes PIN applicable in short horizon event studies. Convergence rates are above 95 % even for the most liquid stocks and the model’s underlying assumptions of independence for the arrival of traders and information events are fulfilled to a much higher degree than in the original approach. An empirical application in an event study type setting demonstrates how official announcements stipulated in German insider trading legislation significantly reduce information asymmetry upon public disclosure.
... This is different from prior studies which focus on the anonymity of liquidity demanders (see, among others, Seppi, 1990;Forster and George, 1992;Benveniste et al., 1992;Madhavan and Cheng, 1997;Garfinkel and Nimalendran, 2003;Theissen, 2003;Reiss and Werner, 2004). The analysis is also undertaken for the same market and thus, does not rely on the comparison between different markets (see, for example, Garfinkel and Nimalendran, 2003;Heidle and Huang, 2002) or different trading venues within the same markets (see, among others, Grammig et al., 2001;Theissen, 2002;Simaan et al., 2003;Reiss and Werner, 2004). Foucault et al. (2007) provide a theoretical model suggesting that the move to anonymity increases (decreases) the aggressiveness of uninformed investors if the participation rate of the informed traders in the trading process is low (high). ...
... Heidle and Huang (2002) investigate whether auction markets (NYSE, AMEX) or dealer markets (NASDAQ) are better able to identify informed traders. Gramming, Schiereck, and Theissen (2001) examine the relation of degree of trader anonymity and the probability of informed trading on the two parallel markets at the Frankfurt Stock Exchange. Both these studies are based on the concept that the non-anonymous environment permits market makers to draw inference about the motives behind trades. ...
Systematic internalizers are single‐dealer platforms run by investment firms that trade out of their own inventories by internalizing the trades off exchanges. We analyze the determinants of dealers' market shares and trading costs. We find that dealer trades have lower price impacts than exchange trades, consistent with uninformed traders seeking out dealers. Due to their ability to avoid trading with informed investors, dealers often undercut the exchange bid–ask spread when the spread is wide and the tick size is not binding. Dealers can therefore offer lower trading costs and gain a higher market share relative to exchanges.
Based on the intraday data in 30 countries, this paper first discovers that investor opinions diverge after a financial disclosure in global markets, which is termed earnings announcement driven disagreement. Next, we document that event-period informed trading is negatively associated with earning announcement driven disagreement. Moreover, such an inverse relation remains stable for various robustness checks. Combined, these findings suggest that informed traders producing private information during an earnings announcement would delay their trades and, thus, lead to greater post-event disagreement. This is in line with the argument that consensus drops as trading on private information rises (Holthausen & Verrecchia, 1990). Finally, we demonstrate that information asymmetry and investor attention play a role in moderating this association.
The (volume-synchronized) probability of informed trading (PIN) is a relative proxy for adverse selection (flow toxicity) in securities trading. We find that (V)PIN puzzlingly explains the discount of U.S. exchange-listed funds. While (V)PIN can unintentionally represent behavioral biases, we suggest the “proportion measure of purchased futures losers or sold future winners” as a more direct proxy for behavioral biases. While the proportion measure is positively and significantly correlated with (V)PIN and the value-weighted discount of closed-end funds, it is unrelated with the price impact parameter, the adverse selection component of the bid-ask spread, and the illiquidity measure. A risk factor defined as the highest-over-lowest excess return of sorted portfolios in terms of the proportion measure, well explains the return of listed funds along with the well-known factors. Lastly, the co-movement of closed-end and exchange-traded fund pairs is pronounced for developed markets and is influenced by the proportion measure.
Easley, Kiefer, O'Hara and Paperman (1996 Easley, D, Kiefer, N, O'Hara, M, Paperman, J (1996): “Liquidity, Information, and Infrequently Traded Stocks”, Journal of Finance, 51, 1405-1436.[Crossref], [Web of Science ®] , [Google Scholar]) introduced a model that enables one to estimate the probability of informed trading in a stock using as input data the numbers of buyer and seller initiated trades over a period. Empirical testing suggests that this model does not fit data well. We formulate several extensions of the model improving its ability to fit data and discuss the effects this has on the accuracy of estimating the probability of informed trading.
Based on intraday data across 41 markets, this study examines whether informed traders exploit trade‐size clustering. Clustering trades are documented to predict price movements, to generate perpetual return impact, and to improve informational efficiency. Collectively, these findings suggest that the clustering strategy is leveraged by the informed to cover up their activities in global markets. In addition, the cross‐country analysis indicates that larger market capacity and better legal protection, as two predominant institutional features, are associated with a lower level of informed‐trade clustering. Finally, such negative interaction attenuates in countries with lot‐size regulations and at bellwether stocks.
Résumé Cet article propose une revue exhaustive de la littérature en microstructure des marchés traitant de la relation entre transparence et qualité des marchés. Nous abordons les contributions théoriques, empirique set expérimentales, en nous focalisant sur les problématiques de la transparence pré-transactionnelle et post-transactionnelle. Une section est consacrée à la transparence sur les marchés obligataires. Si un niveau de transparence minimal apparaît clairement nécessaire, il ressort cependant qu’un certain degré d’opacité peut également bénéficier à l’efficience et la liquidité des marchés. Les prescriptions de la directive MiFID en matière de transparence sont évaluées à la lumière des résultats de la littérature.
Using high-frequency datasets we examine price discovery and its determinants for equivalent instruments across futures markets, electronically traded exchange traded funds (ETFs), and spot markets. We compare futures to ETFs – leveraged and unleveraged – for stock indexes, using both a normal period and the 2008 financial crisis. Yan and Zivot’s information leadership procedure is employed to determine which instrument dominates price discovery. We then examine the determinants and characteristics of the price discovery process using Hasbrouck’s sequential trading model for the price impact of large trades. We find that most price discovery occurs in the more liquid and highly leveraged futures market. However, although liquidity declined in all markets during the financial crisis, the relative contribution of ETFs to price discovery increased. We also find that the information leadership shares of futures and ETFs depend on the ratio of the quoted percentage spread between futures and ETFs and the aggregate volatility occurring in these markets.
This chapter sums up the economic fundamentals of internalised stock trading and attempts to make a case for regulation. It then sketches the current practice of internalisation in Germany, with special emphasis on the 'Xetra Best' facility, a trading venue which tries to integrate internalised trading with an organized market. Subsequently, the chapter turns to a critique of the relevant parts of the EC Markets in Financial Instruments Directive (MiFID), measuring the latter against the fundamental principles of market efficiency and investor protection. Finally, it discusses whether Xetra Best, after some refurbishment, could serve as a blueprint for other European stock exchanges.
Most market places in today's exchange industry operate on fully electronic trading systems. The predominant form of trading systems is the open limit order book pooling all buy and sell limit orders in one single order book. The attractiveness of an order book is determined by its liquidity. Consequently, liquidity is the competitive factor for an exchange. However, it is not the exchange that provides the liquidity but the limit orders standing in the order book. The question is: Who are these traders that provide liquidity on a voluntary basis? A high frequency transaction data set for the German equity market is the basis for Alexandra Hachmeister's extensive empirical analysis. This includes a detailed market description of the German equity market, a new methodological approach for the identification of informed traders and finally the analysis of the individual liquidity providing and demanding behavior of the identified informed traders. Questioning the existing theoretical literature on liquidity provision in equity markets, she finds strong evidence for liquidity providing behavior of informed traders. © Deutscher Universitäts- Verlag | GWV Fachverlage GmbH, Wiesbaden 2007.
This article contributes to the debate about the relative qualities of floor and electronic trading systems by analysing the effects of bringing forward the Xetra closing time from 8.00pm to 5.30pm in November 2003, while the Frankfurt floor remains open until 8.00 pm. This natural experiment provides a 'cleaner' institutional setting than in Venkataraman (2001), as it enables us to investigate trading quality on both platforms for the same stocks in the same country before and after the event. The empirical evidence suggests that primarily institutional investors trading in large stocks transfer to the floor when Xetra closes earlier. It appears that investors remain with Xetra for informed trading though.
The end of the twentieth century was characterized by important changes in financial markets with their development, liberalization and concentration in a cross-border dynamic. A highlight of these changes is the gradual acceleration of comovements between asset prices, both between market segments, but also between countries. If the opening of capital markets enhances the optimal allocation of resources and risks, this opening may also imply a global systemic risk with some intensified comovements observed in times of crisis.
As a result, the multiplication of these fast dynamics of transmission is a major challenge for policy makers (central banks) in terms of financial modelling to ensure the monitoring of the financial system stability as a whole.
The first objective of this thesis consists in the use of innovative techniques in financial econometrics (including multifractal models) that allow to take into account both the long-term dynamics of assets (for instance, linked to the advent of the Euro area) without neglecting the very short term dynamics. A second objective highlights the interest for policy makers in the use of high frequency data. We notably show that the use of such data sheds a new light on the evaluation of the operational framework of the European Central Bank and its interaction with all the financial markets.
Portfolio performance evaluations indicate that managed stock portfolios on average underperform relevant benchmarks. Transaction costs arise inevitably when stocks are bought and sold, but the majority of the research on portfolio management does not consider such costs, let alone transaction costs including price impact costs. The conjecture of the thesis is that transaction cost control improves portfolio performance. The research questions addressed are Do transaction costs matter in portfolio management? and Could transaction cost control improve portfolio performance? The questions are studied within the context of mean-variance (MV) and index fund optimization. The treatment of transaction costs includes price impact costs and is throughout based on the premises that the trading is uninformed, immediate, and conducted in an open electronic limit order book system. These premises characterize a considerable amount of all trading in stocks.
First, cross-sectional models of price impact costs for Swedish stocks are developed using limit order book information in a novel fashion. Theoretical analysis shows that the price impact cost function of order volume in a limit order book with discrete prices is increasing and piecewise concave. The estimated price impact cost functions are negatively related to market capitalization and historical trading activity, while positively related to order size and stock return volatility. Total transaction costs are obtained by adding the relevant commission rate to the price impact cost.
Second, the importance of transaction costs and transaction cost control is examined within MV portfolio optimization. I extend the standard MV model by formulating a quadratic program for MV portfolio revisions under transaction costs including price impact costs. The extended portfolio model is integrated with the empirical transaction cost models developed. The integrated model is applied to revise portfolios with different net asset values and across a wide range of risk attitudes. The initial (unrevised) portfolios are capitalization-weighted and contain all Swedish stocks with sufficient data. The standard MV model, which neglects transaction costs, realizes non-trivial certainty equivalent losses relative to the extended model, which, in addition, exhibits lower turnover, higher diversification, and lower transaction costs incurred. The evidence suggests that transaction cost control improves performance in MV revisions, and that price impact costs are worthwhile to consider.
Third, the research questions are studied within index fund management. I formulate two index fund revision models under transaction costs including price impact costs. Each index fund optimization model is integrated with the empirical transaction cost models. Transaction costs including price impact costs, cash flows, and corporate actions are incorporated in the empirical tests, which use ten years of daily data. In the tests, the two index fund revision models and several alternative approaches, including full replication, are applied to track a Swedish capitalization-weighted stock index. Instead of using an extant index, an index is independently calculated according to a consistent methodology, mimicking that of the most used index in the Nordic region, the OMX(S30). The alternative approaches are tested under a number of variations including different tracking error measures and different types and degrees of transaction cost control. Index funds implemented by the index fund revision models under transaction cost control dominate, in all dimensions of tracking performance considered, their counterparts implemented without transaction cost control as well as the funds implemented by full replication. Price impact costs constitute the majority of the transaction costs incurred. Additional results indicate that some common tracking error measures perform similar and that the technique to control transaction cost by constructing an index fund from a pre-defined subset of the most liquid index stocks is not efficient.
The overall conclusion of the thesis is that transaction costs matter, that transaction cost control improves portfolio performance, and that price impact costs are important to consider.
Keywords: portfolio optimization, transaction costs, price impact costs, market impact, electronic limit order book, index fund optimization, equity indexing, full replication, portfolio revision
JEL Classification: G00, G11, C61
Suggested Citation:
Olsson, Rickard, Portfolio management under transaction costs: Model development and Swedish evidence (2005). Olsson, R. (2005). Portfolio management under transaction costs: Model development and Swedish evidence. (PhD thesis). Umeå School of Business, Economics and Statistics, Umeå University, Sweden.
We are the first to evaluate the impact of the trading floor closure on the corresponding efficiency of the stock price formation process on the Toronto Stock Exchange (TSX). Utilizing short-horizon return predictability as an inverse indicator of market efficiency, we demonstrate that while the switch to all electronic trading resulted in higher volume and lower trading costs, the information asymmetry among investors increased as more informed and uninformed traders entered the market. The TSX trading floor closure resulted in a significant decrease in informational efficiency, and it took about six years for efficiency to return to its pre-all-electronic-trading level. In multivariate setting, we provide evidence that changes in information asymmetry and increased losses to liquidity demanders due to adverse selection account for the largest variations in the deterioration of the aggregate level of informational efficiency. Our results suggest that electronic trading should complement, rather than replace, the exchange trading floor.
Market transparency is an integral part of market design. The literature offers opposing views on the benefits and detriments of providing more transparency that have far-reaching implications for market participants and regulators. Market microstructure theory provides important and often conflicting insights to policy makers. Both empirical and experimental tests should guide transparency policy. This chapter provides a survey and synthesis of empirical and experimental research on market transparency and disclosure. Different aspects of transparency and trade disclosure within the context of market quality are discussed. The sole focus on empirical and experimental research aims to complement the theory covered in previous chapters.
We study the effects of a change from a pre-trade transparent limit order book to an anonymous electronic limit order book. We use the Probability of Informed Trading (PIN) as a proxy for the participation rate of informed traders to test a theoretical prediction of Foucault, Moinas, and Theissen (2007). However, we do not find significant explanatory power for the PIN measure in explaining bid-ask spreads after a change to anonymous trading. More generally, we do not find unambiguous evidence of an improvement in market quality, measured by bid-ask spreads, intraday volatility, and trading volume. We also find that there is no substantial change in upstairs trading., seminar participants at Hanken School of Economics, the GSF Summer Research Workshop, and the Universität Mannheim Summer School for comments and suggestions on earlier versions of this paper. All errors are of course ours. In addition, we thank the OMX Group for providing data. We gratefully acknowledge financial support from the Hanken Foundation, the Finnish Foundation for Advancement of Securities Markets, Säästöpankkien tutkimussäätiö, and Osuuspankkien tutkimussäätiö. Some of this research was conducted at the Australian School of Business, UNSW, Sydney.
As a direct measurement of information asymmetry among investors, PIN research has become the popular area in financial research. However, due to the localness of software optimization algorithm and the uncontinuity of likelihood function, there are some problems in PIN estimation, such as dependence on initial value and corner solution. These problems could induce inaccuracy of PIN estimation. This paper proposes two methods to help solving the problem and make the PIN estimation more accurate: initial value exhaustion method and Monte-Carlo method.
A trend towards computerized transaction points out a significant query that either electronic cost which is occurring in trading system is lower than that of trading through floors. Trading system is how orders are handled and how they are administered and how individual prices are been setup. The trading affects the profitability and hence it affects traders' behavior, price formation and trading cost. Data of returns of KSE 100 index from the period of January1998 to June 2008 and the variables that have the significant difference in the Electronic system are volume, market capitalization, volatility and turnover. Thus, electronic system shows more information in a limited time when volume and return volatility is high. The results and findings indicated that the electronic system has a significant edge over trading by floors.
This study examines the quality of derivatives pricing in the market in which liquidity is dominated by an alternative market. We use US interest rate futures from the side-by-side open outcry and electronic markets, in which electronic markets dominate liquidity. We find that the bid-ask spreads in illiquid open outcry markets have increased substantially since electronic markets became a major part of the market liquidity. Accordingly, the implicit trading costs in open outcry markets have significantly increased. We also show that the volatility of bid-ask spreads in illiquid open outcry markets has increased, which is consistent with a decrease in the depth of the market. In addition, we find that the fast rate of price discovery in electronic markets instabilizes the bid-ask spread in open outcry market. Our results are particularly important for practitioners in that the performance of their portfolio and risk managements critically depends on which market dominates liquidity.
We address the role of information heterogeneity in the Euro interbank market for unsecured term lending. We use high-frequency quotes of bid and ask prices to estimate probabilities of informed trading for contract maturities from one month to one year. The dataset spans from November 2000 to March 2008, and includes the relevant events that characterize the developments of the euro area money market. We find that the probability of finding a trading counterparty with a wider information set has risen since the eruption of the turmoil. Our results also show that the probability of trading with a better-informed bank is higher on days when open market operations take place, and at the end of the maintenance period. This effect has strengthened during the turmoil. This suggests that the loose supply of money of the ECB has not dampened the distortions arising from asymmetric information in the unsecured money market.
This paper studies the upstairs market of the Stock Exchange Trading System (SETS) of the London Stock Exchange (LSE). We hypothesise that the implicit interaction between the upstairs and the downstairs markets at the LSE alters the pricing mechanism at the upstairs market. We show that market makers employ “cluster undercutting” practices in the upstairs market, which are based on a notional minimum price increment and resemble an anchoring-and-adjustment effect. In particular, we report that liquidity providers consistently buy just below the implicit minimum price increment and consistently sell just above it. This finding is strongly related to stock-price momentum and periods of increased trade intensity. Overall, this effect has only a weak connection to differences in informed trading and is mostly related to the notional price barriers and resistance levels introduced by the minimum tick size of the order book.
We investigate the effect of the removal of broker identities on institutional and individual order submissions on the Australian Stock Exchange (ASX). We document declines in order aggressiveness and effective spreads for both institutional and individual investors after the switch to the anonymous trading system. Institutions are more willing to improve the best quotes than individuals, especially in the anonymous market. Anonymity also reduces the “picked off” risk for individual limit orders. Overall, our findings highlight the benefits of withholding brokers' IDs in the form of lower transaction costs and higher liquidity supply and thus support the ASX's decision to stop disclosing broker identity information.
Using a sample of Italian firms, this paper investigates whether separate financial statements are useful to capital market investors and whether IFRS are more value-relevant than domestic GAAP. This paper finds that separate financial statements are value-relevant regardless of the accounting standard set. However, while results are robust for book value, they provide mixed evidence on net income. Contrary to expectations, this paper also finds that separate financial statements under IFRS do not provide incremental information content beyond that provided under domestic GAAP. Actually, there is some evidence that domestic GAAP are more value-relevant than IFRS.Finally, this paper documents the important role of model specification in value-relevance studies.
We study the role of informed trading in a fragmented financial market under the absence of inter-market price priority. Due to frictions in traders’ market access, liquidity providers on alternative trading platforms may be exposed to an increased adverse selection risk. As a consequence, the main market dominates (offers better quotes) frequently albeit charging higher transaction fees. The empirical analysis of a dataset of trading in French and German stocks suggests that trades on Chi-X, a lowcost trading platform, carry significantly more private information than those executed in the Primary Markets. Consistent with our theory, we find a negative relationship between the competitiveness of Chi-X’s quotes and this excess adverse selection risk faced by liquidity providers in the cross-section. Our results have some implications for the design of best-execution policies.
We examine the liquidity and market depth characteristics of eight different futures contracts that are traded on electronic markets. We decompose the volatility of futures contracts into its trade and nontrade components using Hasbrouck’s (2004) model and report the impact of these trades on prices. Utilizing Engle and Lange’s (2001) VNET measure we report the net directional volumes that cause a specific percentage price change. Our results show that trades during more liquid time regimes explain a larger percentage of volatility, which is consistent with Chordia, et al.’s (2008) view that liquidity increases informational efficiency. Furthermore, our results show that informational efficiency is higher for more liquid contracts such as stock index or currency futures than for less liquid commodity and VIX futures contracts. Finally, we document the adverse effects of the 2008 crises on the liquidity of the e-mini S&P 500, gold and VIX futures.
This paper summarizes the responses to a questionnaire sent to equity traders through TraderForum of the Institutional Investor. The respondents manage in total a very significant percentage of equity assets under management in the United States. The focus of the questions was the extent of the demand for immediate execution of orders. We found that the majority of traders are willing to trade patiently if this reduces execution costs. Many traders indicate that they frequently delay trades to obtain better prices. Most respondents indicate that they are typically given more than a day to implement a large order, that they typically break up more than 20% of their large orders for execution over time, and that they regularly take more than a day for a large order that has been broken into lots to be executed completely. There is a generally positive view of alternative electronic trading systems, such as Instinet and Investment Technology Group's POSIT. The key motives for trading on these systems are reduced market impact, lower spreads, better liquidity, and anonymity. The respondents indicate that the key changes that would make alternative electronic systems more attractive are an increase in execution rates and more convenient times of trading. The responses to the survey also show that alternative electronic systems would be used more if the traders did not have soft dollar arrangements.
The author assumes that customers do not continuously participate in all markets and that intermediaries are repositories of information about the ("unexpressed") demands of currently nonparticipating customers. A model of downstairs (i.e., centralized) versus upstairs (i.e., fragmented) markets is developed based on the assumption that upstairs (and not downstairs) dealers may possess information about unexpressed demand. The equilibrium liquidity of both markets is characterized by the trade-off between the benefits of information about unexpressed demand and the cost to the customer of trading in a fragmented market. Copyright 1992 by University of Chicago Press.
Since the depth and liquidity of a market depend on the entry decisions of all potential participants, each trader assesses
them according to conjectures about entry by others. If trade is equally costly across markets, this externality leads to
the concentration of trade on one market. If not, it can produce multiple conjectural equilibria, some where trade concentrates
on one market and others where large traders resort to a separate market or to search for a trading partner. While fragmentation
is welfare-reducing in the two-market case, no such ranking is possible if it involves off-exchange search.
When a security trades at multiple locations simultaneously, an informed trader has several avenues in which to exploit his
private information. The greater the proportion of liquidity trading by “large” traders who can split their trades across
markets, the larger is the correlation between volume in different markets and the smaller is the informativeness of prices.
We show that one of the markets emerges as the dominant location for trading in that security. When informed traders can use
their information for more than one trading period, the timely release of price information by market makers at one location
adversely affects the profits informed traders expect to make subsequently at other locations. Market makers, competing to
offer the lowest cost of trading at their location, consequently deter informed trading by voluntarily making the price information
public and by “cracking down” on insider trading.
Using the model structure of Easley and O'Hara (Journal of Finance, 47, 577–604), we demonstrate how the parameters of the
market-maker's beliefs can be estimated from trade data. We show how to extract information from both trade and no-trade intervals,
and how intraday and interday data provide information. We derive and evaluate tests of model specification and estimate the
information content of differential trade sizes. Our work provides a framework for testing extant microstructure models, shows
how to extract the information contained in the trading process, and demonstrates the empirical importance of symmetric information
models for asset prices.
A good deal is known about how broker-dealers, the so-called “sell-side” of the market, execute trades through stock exchange trading systems. However, very little is known about how institutional investors, the “buy-side” of the market, manage the orders they submit to broker-dealers, or how they might manage them differently if they could bypass traditional sell-side trading systems and intermediaries.
This paper investigates the effect of trade size on security prices. We show that trade size introduces an adverse selection problem into security trading because, given that they wish to trade, informed traders perfer to trade larger amounts at any given price. As a result, market makers' pricing strategies must also depend on trade size, with large trades being made at less favorable prices. Our model provides one explanation for the price effect of block trades and demonstrates that both the size and the sequence of trades matter in determining the price-trade size relationship.
This paper examines the degree of anonymity - the extent to which a trader is recognized as informed or not - on alternative market structures, and its impact on trading costs and the trading strategies of insiders. We find evidence that is consistent with less anonymity on the NYSE specialist system compared to the NASDAQ dealer system. Specifically, when corporate insiders trade medium sized quantities (500-9,999 shares inclusive), NYSE listed stocks exhibit larger increases in proportional effective spreads on insider trading days than NASDAQ stocks. Taken together, these findings are consistent with Barclay and Warner's contention that STEALTH (medium sized) trades are more likely based on private information and insider trades are more transparent on the NYSE specialist system relative to the NASDAQ dealer system. We also find that insiders in NYSE listed firms are less likely to trade strategically by breaking up trades into small quantities, when compared to their NASDAQ counterparts. One interpretation of this is that the benefits of strategic trading are mitigated by the higher transparency on the NYSE. An implication of our findings is that if less anonymity encourages price discovery, mitigates adverse selection problems, and reduces transaction costs, then the specialist system may yield benefits that are not available on completely anonymous electronic systems.
The trade process is a stochastic process of transactions interspersed with periods of inactivity. The realizations of this process are a source of information to market participants. They cause prices to move as they affect the market maker's beliefs about the value of the stock. We fit a model of the trade process that allows us to ask whether trade size is important, in that large and small trades may have different information content (they do, but this varies across stocks); whether uninformed trade is i.i.d. (it is not); and, whether large buys and large sells are equally informative (they differ only marginally). The model is fitted by maximum likelihood using transactions data on six stocks over 60 days.
We estimate and examine certain characteristics of the order flow through an electronic open limit order book, using order (not trade) data. In doing this, we bring out new evidence on order flow from a market with microstructure different from that of the NYSE. We find that the proportion of informed orders is less than 10%, lower than previous estimates. Informed traders choose smaller orders than uninformed traders, but do not materially differ in their choice of limit or market orders. The proportion of informed investors is similar between good and bad news days. Finally, there are U-shaped intraday patterns in order arrival, and the information content of the order flow appears to follow this pattern across the day.
We analyze how the anonymous trading of uninformed agents affects the characterization of security market equilibrium. We show that the degree of anonymity provided by a market alters the distribution of wealth across agents, the depth of the market, and the incentive agents have to acquire private information about a security's fundamental value. Moreover, the nature of these effects depends on the type of information about uninformed trading that is revealed to market participants. Our results have implications for sunshine trading, dual trading, brokerage relationships, automation and decentralization of markets, and firms' security listing choices. G10, L10.
The presence of traders with superior information leads to a positive bid-ask spread even when the specialist is risk-neutral and makes zero expected profits. The resulting transaction prices convey information, and the expectation of the average spread squared times volume is bounded by a number that is independent of insider activity. The serial correlation of transaction price differences is a function of the proportion of the spread due to adverse selection. A bid-ask spread implies a divergence between observed returns and realizable returns. Observed returns are approximately realizable returns plus what the uninformed anticipate losing to the insiders.
Exchange members claim that the professional relationships that evolve on exchange floors yield benefits not easily duplicated by an anonymous exchange mechanism. We show that longstanding relationships between brokers and specialists can mitigate the effects of asymmetric information. Moreover, a specialist who actively attempts to differentiate between informed and uninformed traders can achieve equilibria that Pareto-dominate an equilibrium in which the two types of trades are pooled. Our model also elucidates the role of block trading houses in mitigating information problems in the block market.
Nasdaq's Small Order Execution System (SOES) allows orders to be submitted by computer, thereby assuring rapid execution at quoted prices. We examine trading in the 20 largest Nasdaq stocks around the time of a rule change that reduced the largest SOES trades from 1000 to 500 shares. We show that SOES trades contain information about short-term price movements and that SOES trading declined dramatically with the rule change. However, quoted and effective spreads were unaffected by the rule change.
This paper considers a securities market in which orders are channeled through professional broker-dealers such as London's market makers or the large banks operating on continental exchanges. If these dual-capacity dealers can judge the motives behind their customers' orders, they can trade profitably on their own account (even if they cannot “front run,” that is, trade on their own account before executing a customer order). It is shown that the dealers have an incentive to satisfy roughly half of their customers' orders from their own inventory if they are sure that orders are liquidity-motivated and not based on inside information. As a result of dual-capacity dealing, transaction costs for liquidity-motivated traders in the aggregate fall, but they rise for those traders who are unable to convince any dealer that they have no inside information. The liquidity of the main market worsens, even though its effective liquidity for customers whose orders are partly filled from broker-dealer inventories improves.
In this research, we investigate the informational role of financial analysts. Using a trade-based empirical technique, we estimate the probability of information-based trading for a sample of NYSE stocks that differ in analyst coverage. We determine how this probability differs across stocks followed by many analysts, and we investigate whether analysts increase or create the flow of information. We also determine the `normal' level of noise trading in each sample stock, thereby giving us the ability to assess the depth of the market for stocks with differing analysts followings. Our most important empirical result is that the number of financial analysts is not a good proxy for information-based trading.
In this article, we consider the possibility that some liquidity traders preannounce the size of their orders, a practice
that has come to be known as “sunshine trading”. Two possible effects preannouncement might have on the equilibrium are examined.
First, since it identifies certain trades as informationless, preannouncement changes the nature of any informational asymmetries
in the market. Second, preannouncement can coordinate the supply and demand of liquidity in the market. We show that preannouncement
typically reduces the trading costs of those who preannounce, but its effects on the trading costs and welfare of other traders
are ambiguous. We also examine the implications of preannouncement for the distribution of prices and the amount of information
that prices reveal.
In this article I develop a model that accounts for interdependence between trading costs in various asset markets arising
from the optimizing behavior of liquidity traders. The model suggests that noise trading is an important determinant of the
liquidity of asset markets and provides a positive theory for diversified asset holdings by risk-neutral liquidity traders.
It is demonstrated that markets in stock index futures or, more generally, in baskets of securities, provide a preferred trading
medium for uninformed liquidity traders who wish to trade portfolios, because adverse selection costs are typically lower
in these markets than in markets for individual securities. Thus, an explanation is provided for the immense liquidity and
popularity of markets in stock index futures. Implications are also developed for the effect of the introduction of a basket
on market liquidity and the informativeness and variability of component security prices, and for the price relationship between
the basket and its underlying portfolio.
We analyze the ability of various market mechanisms to provide liquidity for large equity trades. Using data on 21,077 block
transactions in Dow Jones stocks, we find that the “downstairs” NYSE floor market is a significant source of liquidity. Although
negotiation in the informal “upstairs” market provides better execution than the downstairs market for large trades, these
differences are economically small. We find, however, that upstairs markets are used by traders who can credibly signal that
their trades are liquidity motivated. Thus, upstairs markets allow trades that may not otherwise occur.
Automated trade execution systems are examined with respect to the degree to which they automate the price discovery process. Seven levels of automation of price discovery are identified, and 47 systems are classified according to these criteria. Systems operating at various levels of automation are compared with respect to age, geographical location, and type of securities traded. Information provided to market participants and asymmetries of information between traders with direct access to the automated market and outside investors also are examined. It is found, for example, that the degree of asymmetric information increases with the level of automation of price discovery. The potential for trading abuses related to prearranged trading, noncompetitive execution, and trading ahead of customers is analyzed for each level of automation. Certain levels of automation widen the opportunities for trading abuses in some respects, but may narrow them in others.
For New York Stock Exchange listed securities, the price execution of seemingly comparable orders differs systematically by location. In general, executions at the Cincinnati, Midwest, and New York stock exchanges are most favorable to trade initiators, while executions at the National Association of Security Dealers are least favorable. These intermarket price differences depend on trade size, with the smallest trades exhibiting the biggest per share price difference. Collectively, these results raise questions about the adequacy of the existing intermarket quote system, the broker's fiduciary responsibility for 'best execution,'and the propriety of order flow inducements. Copyright 1993 by American Finance Association.
This article investigates whether differences in information-based trading can explain observed differences in spreads for active and infrequently traded stocks. Using a new empirical technique, we estimate the risk of information-based trading for a sample of New York Stock Exchange (NYSE) listed stocks. The authors use the information in trade data to determine how frequently new information occurs, the composition of trading when it does, and the depth of the market for different volume-decile stocks. Their most important empirical result is that the probability of information-based trading is lower for high volume stocks. Using regressions, we provide evidence of the economic importance of information-based trading on spreads. Coauthors are Nicholas M. Kiefer, Maureen O'Hara, and Joseph B. Paperman. Copyright 1996 by American Finance Association.
Purchased order flow refers to the practice of dealers or trading locales paying brokers for retail order flow. It is alleged that such agreements are used to 'cream skim' uninformed liquidity trades, leaving the information-based trades to established markets. We develop a test of this hypothesis, using a model of the stochastic process of trades. We then estimate the model for a sample of stocks known to be used in order purchase agreements that trade on the New York Stock Exchange (NYSE) and the Cincinnati Stock Exchange. Our main empirical result is that there is a significant difference in the information content of orders executed in New York and Cincinnati, and that this difference is consistent with cream-skimming. Copyright 1996 by American Finance Association.
With dual trading, brokers trade both for their customers and for their own account. The authors study dual trading and find that customers who are less likely to be informed have higher expected profits with dual trading while customers who are more likely to be informed have higher expected profits without dual trading. They also examine the effects of frontrunning. The authors test the major empirical implications of their model. Consistent with the model, dual traders earn higher profits than nondual traders, and customers of dual-trading brokers do better than customers of nondual-trading brokers. Copyright 1992 by American Finance Association.
This paper evaluates alternative methods for classifying individual trades as market buy or market sell orders using intraday trade and quote data. The authors document two potential problems with quote-based methods of trade classification: quotes may be recorded ahead of trades that triggered them, and trades inside the spread are not readily classifiable. These problems are analyzed in the context of the interaction between exchange floor agents. The authors then propose and test relatively simple procedures for improving trade classifications. Copyright 1991 by American Finance Association.
Infrequently traded stocks tend to have higher bid-askspreads than frequently traded stocks. We use a new empirical technique to investigate the risk of information- based trading in active versus inactive stocks. We estimate the stochastic process of trades by maximum likelihood. Using a sample of NYSE stocks, we find that actively traded stocks have a much greater rate of uninformed trade. This suggests that the larger spreads are due at least in part to the higher risks associated with making a market in infrequently traded stocks.
The electronic trading system Xetra of the German Security Exchange provides a unique data source on the equity trades of 451 large traders located in 23 different cities and 8 European countries. We explore informational asymmetries across the trader population: Traders located outside Germany in non-German speaking cities show lower proprietary trading profits. Their underperformance is not only statistically significant, it is also of economically significant magnitude and occurs for large blue chip stocks. We also examine if a trader location in Frankfurt as the financial center or local proximity of the trader to the corporate headquarter of the traded stock or affiliation with a large financial institution results in superior trading performance. The data provides no evidence for a 'financial center advantage'. But the data show decreasing 'institutional scale economies' and an information advantage due to corporate headquarter proximity for high frequency (intra-day) trading.
With the celebrated model of Black and Scholes in 1973 the development of modern option pricing models started. One of the assumptions of the Black and Scholes model ist that the risky asset evolves according to the geometric brownian motion which implies normal distributed returns. As empirical investigations show, the stock returns do not follow a normal distributions, but are leptokurtic and to some extend skewed. The following paper proposes so-called Esscher-EGB2 option pricing model, where the price process is modeled by an exponential EGB2-Levy-motion, implying that the returns follow an EGB2 distribution and the equivalent martingale measure is given by the Esscher transformation --
We identify incentives generated by the Bretton Woods II system that may have contributed to the sub-prime liquidity crisis now working its way through the international monetary system. We then evaluate the persistent conjecture that the liquidity crisis is or will become a balance of payments crisis for the United States. Given that it happens, the additional costs associated with a sudden stop of net capital flows to the United States could be quite substantial. But we observe that emerging market governments have continued to acquire US assets even as yields have fallen, and the incentives for continuing to do so remain strong. Moreover, the Bretton Woods II system, which has clearly been the most resilient of the forces driving current markets, continues to generate low real interest rates in industrial countries and growth in emerging markets that will help limit the damage from the liquidity crisis. Copyright © 2009 Blackwell Publishing Ltd.
This paper delineates the link between the existence of information, the timing of trades, and the stochastic process of prices. The authors show that time affects prices, with the time between trades affecting spreads. Because the absence of trades is correlated with volume, the authors' model predicts a testable relation between spreads and normal and unexpected volume, and demonstrates how volume affects the speed of price adjustment. Their model also demonstrates how the transaction price series will be a biased representation of the true price process, with the variance being both overstated and heteroskedastic. Copyright 1992 by American Finance Association.
In this paper we estimate price effects of trading on the Paris Bourse. We use several methods to decompose price effects into transitory and permanent parts. First, we use the Glosten (1994) model for an electronic order-driven market. In line with theoretical predictions, the price impact increases with trade size, and is estimated between 25% (for small transactions) and 60% (for large transactions) of the total spread. We then use a reduced form approach based on a multi-period Vector Auto Regression. The VAR estimates of the permanent price impact are between 40% and 115% of the spread, much larger than the estimates of Glosten's one-period model. We check the robustness of these results by less restrictive, direct estimates of long-run price effects and confirm the results of the VAR analysis. We separately analyze the price effects of off-exchange transactions. These appear to have no long run price impact at all. In all results, there is no reversal of the direction of trade, which suggests that inventory control is unlikely to be important on the Paris Bourse.
Price volatility and market efficiency is examined for an automated periodic auction mechanism and a continuous automated auction, using data on five futures contracts which obviate ambiguities due to periods of non-trading.
The last decade has witnessed a dramatic increase in both the number and the market share of screen-based trading systems. Electronic trading systems do offer lower operating costs and the possibility of remote access to the market. On the other hand there are arguments based on the anonymity of electronic trading systems which suggest that adverse selection is a more severe problem in electronic trading systems and, therefore, the bid-ask spreads may be higher. The present paper addresses the issue of transaction costs in floor and computerized trading systems empirically. In Germany, floor and screen trading for the same stocks exist in parallel. Both markets are liquid and operate simultaneously for several hours each day. An analysis of the market shares of the competing systems reveals that the electronic trading system is relatively less attractive for less liquid stocks and in the presence of higher return volatility. The bid-ask spreads reveal a similar pattern. The floor ap...
This paper studies the interaction between dealer markets and a relatively new form of exchange, passive crossing networks, where buyers and sellers trade directly with one another. We find that the crossing network is characterized by both positive ("liquidity") and negative ("crowding") externalities, and analyze the e#ects of its introduction on the dealer market. Traders who use the dealer market as a "market of last resort" can induce dealers to widen their spread and lead to more e#cient subsequent prices, but traders who only use the crossing network can provide a counterbalancing e#ect by reducing adverse selection and inventory holding costs. # Simon School of Business, University of Rochester and the Graduate School of Business, Stanford University. Helpful comments and suggestions by an anonymous referee, Rene Stulz (the editor), and Robert Hendershott are gratefully acknowledged. Competition between exchanges for order flow is a growing phenomenon in financial markets. Fr...
Auction markets are often touted as better trading mechanisms for unmasking informed traders than dealer markets. Our analysis of firms that transfer to an alternative exchange structure suggests that traders are more anonymous in a competing dealer market than in an auction environment. Our evidence also shows that when firms move to a new market structure, the changes in the risk of trading with an informed trader are associated with the changes in the bid-ask spread. Moreover, the changes in the probability of transacting with an informed trader are more pronounced for firms that are less liquid prior to the relocation. Our results provide evidence of differences in bid-ask spreads between dealer and auction markets that are induced by differences in market structure.
One Day in the Life of a Very Common StockThe Information Content of the Trading Proc-ess
- D Easley
- N Kiefer
- Hara
Easley, D., N. Kiefer and M. O’Hara, 1997a, “One Day in the Life of a Very Common Stock,” Review of Financial Studies, 10, 805-835. r24 Easley, D., N. Kiefer and M. O’Hara, 1997b, “The Information Content of the Trading Proc-ess,” Journal of Empirical Finance, 4, 159-186
Market Structure and Trader Anonymity: An Analysis of Insider Trading,” working paper, Loyola University of Chicago and University of FloridaBid, Ask and Transaction Prices in a Specialist Market with Heterogeneously Informed Traders
- J Garfinkel
- M Nimalendram
- L R Glosten
- P Milgrom
Garfinkel, J. and M. Nimalendram, 1998, “Market Structure and Trader Anonymity: An Analysis of Insider Trading,” working paper, Loyola University of Chicago and University of Florida, September. r25 Glosten, L.R. and P. Milgrom, 1985, “Bid, Ask and Transaction Prices in a Specialist Market with Heterogeneously Informed Traders,” Journal of Financial Economics, 14, 71-100
The importance of firm quotes and rapid executions
- Harris
Cream-skimming or profit-sharing?. The curious role of purchased order flow
- Easley
Crossing networks and dealer markets
- Hendershott
Price improvement in dealership markets. Working paper, Columbia University
- M Rhodes-Kropf
In search of liquidity
- Madhavan