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Designated Market Makers in Electronic Limit Order Books - A Closer Look
Abstract
This paper takes a detailed look on the activities of designated market makers in the electronic limit order book Xetra of Deutsche Börse in order to enhance our understanding of the empirical finding of prior literature that designated market makers increase liquidity and firm values. We find designated market makers' liquidity provision is exploited at times of high information asymmetry, as measured through market based measures. Market makers' role in call auctions, particularly those after trading halts due to excessive volatility, is larger than that during continuous trading and their activities tend to stabilize prices.
... Consequently, there is a justified inclination to introduce DMMs in lower capitalization stocks rather than larger caps. An empirical study conducted by Theissen et al. (2013) utilizing a dataset covering 110 German stocks delves into the trading activity of market makers. The study Zb. ...
Many exchanges around the globe have implemented market-making schemes inan attempt to mitigate liquidity risk and enhance trading volume. This researchexamines the impact of designated market makers on stock liquidity in frontiermarkets, specifically measured by bid-ask spreads and trading turnover. Using adifference-in-differences analysis, we studied 19 stocks that introduced designatedmarket makers at the Zagreb Stock Exchange and Ljubljana Stock Exchangebetween May 2010 and January 2022. To the best of our knowledge, this is the firststudy investigating the impact of market makers in these specific markets and onlythe second in frontier markets overall. As expected, we find a significant reductionin bid-ask spreads for most stocks following the introduction of market makers.However, unlike findings of studies conducted in more developed markets, ourresults for turnover are not conclusive, suggesting that market makers alone maynot be sufficient to overcome structural impediments to market liquidity in frontiermarkets, such as lack of free float and the dominance of large investors with long-term investment horizons.
This paper studies the effect of the bid-ask spread on asset pricing. We analyze a model in which investors with different expected holding periods trade assets with different relative spreads. The resulting testable hypothesis is that market-observed expexted return is an increasing and concave function of the spread. We test this hypothesis, and the empirical results are consistent with the predictions of the model.
Having obtained a complete dataset of corporate press releases issued between April 2006 and August 2009, we analyze the stock price reactions to various types of corporate events. Besides confirming the previously-documented empirical regularities about the reaction to financial news, we also document a strong market response to news about corporate strategy, customers & partners, products & services, management changes, and legal issues. In addition, we find that return volatility generally increases and liquidity decreases in the month after the announcement. Investigating separately the time periods before and during the financial crisis, we observe that the response to certain types of news has changed. For example, during the crisis period, news that signal higher and more stable future cash flows, such as announcements about corporate restructuring, new corporate partners, successful research completion, FDA approvals, and legal settlements lead to more positive price reactions. On the other hand, events that are perceived to decrease future cash flows and increase their uncertainty, such as announcements about legal troubles, FDA rejections, and failed research efforts have a more negative effect on stock prices. Moreover, announced plans to raise funds through equity or debt offerings are perceived less negatively, and announcements of share buybacks lead to even higher abnormal returns than in the pre-crisis period. We also show that during the more uncertain crisis period, news announcements tend to lead to larger volatility increases.
A recent innovation in equity markets is the introduction of market maker services paid for by the listed companies themselves. We investigate what motivates the issuing firms to pay a cost for improving the secondary market liquidity of their listed shares. We show that a contributing factor in this decision is the likelihood that the firm will interact with the capital markets in the near future. We show that the typical firm employing a DMM is more likely to need more capital, or plan to distribute cash through stock repurchases. It is also more likely to have exit by its insiders. We also show significant reductions in liquidity risk and cost of capital for firms that hire a market maker. Firms that prior to hiring a market maker have a high loading on a liquidity risk factor, experience a reduction in liquidity risk down to a level similar to that of the larger and more liquid stocks on the exchange.
We examine the role of market makers in facilitating price discovery. We show that a specialist may experiment with prices to induce more informative order flow, thereby expediting price discovery. Market makers in a multiple-dealer system, unlike a specialist system, do not have the incentives to perform such costly experiments because of free-rider problems. Consequently, the specialist system may provide open markets where bid-ask spreads. We analyze the effect of experimentation on the bid-ask spread and provide an exploratory analysis of intraday specialist data that is consistent with our price experimentation hypothesis. Article published by Oxford University Press on behalf of the Society for Financial Studies in its journal, The Review of Financial Studies.
Opening mechanisms play a crucial role in information aggregation following the overnight nontrading period. This article
examines the process of price discovery at the New York Stock Exchange single-price opening auction. We develop a theoretical
model to explain the determinants of the opening price and test the model using order-level data. We show that the presence
of designated dealers facilitates price discovery relative to a fully automated call auction market. This is consistent with
specialists extracting information from observing the evolution of the limit order book. In addition, the specialist's opening
trade reflects noninformational factors such as price stabilization requirements.
One way to improve the liquidity of small stocks is to subsidize the providers of liquidity. These
subsidies take many forms such as informational advantages, priority in trading with incoming order flow, and fee rebates for limit order traders. In this study, we examine another type of subsidy – directly paying liquidity providers to provide contractual improvement in liquidity. Our specific focus here is the 2002 decision by the Stockholm Stock Exchange to allow listed firms to negotiate with liquidity providers to set maximum spread widths and minimum depths. We find, for a sample of stocks that entered into such an arrangement, a significant improvement in market quality with a decline in quoted spreads and an increase in quoted depth throughout the limit order book. We also find evidence that suggests that there are improvements beyond those contracted for. In addition, both inter and intraday volatility decline following the entry of committed liquidity providers for these stocks.
Traders benefit by the reduced costs as well as by the ease of finding liquidity as seen in the
increased trade sizes. We also find that a firm’s stock price subsequent to entering into the agreement rises in direct proportion to the improvement in market quality Thus, we find overwhelming evidence of liquidity benefits to listed firms of entering into such contracts which suggests that firms should consider these market quality improvement opportunities as they do other capital budgeting decisions and that there are residual benefits beyond those contracted for.
This study compares the components of the bid-ask spread estimated from quotes that reflect the trading interest of specialists with those estimated from limit-order quotes and all available quotes for a sample of New York Stock Exchange (NYSE) stocks. The results show that the adverse selection component of the spread estimated from specialist quotes is significantly smaller than the corresponding figures from limit-order quotes and entire quotes. We interpret this as evidence that NYSE specialists transfer at least a part of adverse selection costs to outsiders through the discretionary use of limit orders. Our results show that the estimation/interpretation of the components of the spread using quote data that include both specialist and limit-order interests is problematic. Copyright 2004 by the Eastern Finance Association.
I establish stylized empirical facts about the trading behavior of New York Stock Exchange specialists. Specifically, I look at the effect of future price movements, the specialist's explicit role, and the specialist's inventory levels on specialist trading behavior. The motivation for this empirical study is to infer whether the specialist behaves like an active investor who has an information advantage which he obtains while acting as a broker for other traders. If this were the case, one would expect that the specialist would engage in a profit maximizing strategy, buying low and selling high, which is opposite to the prediction of the traditional inventory model. I find that specialists behave like active investors who seek to buy stocks when prices are low and to sell when prices are high. I also find that when specialists are not performing their trading obligations of being on the opposite side of the market they are in almost 85 percent of their trades, buying low and selling high. The findings of this paper indicate that the NYSE specialist is best represented in theoretical models as a constrained profit maximizing, informed investor rather than as a zero profit trader.
This paper characterizes the trading strategy of a large high frequency trader (HFT). The HFT incurs a loss on its inventory but earns a profit on the bid-ask spread. Sharpe ratio calculations show that performance is very sensitive to cost of capital assumptions. The HFT employs a cross-market strategy as half of its trades materialize on the incumbent market and the other half on a small, high-growth entrant market. Its trade participation rate in these markets is 8.1% and 64.4%, respectively. In both markets, four out of five of its trades are passive i.e., its price quote was consumed by others.
This study investigates whether marketwide liquidity is a state variable important for asset pricing. We find that expected stock returns are related cross-sectionally to the sensitivities of returns to fluctuations in aggregate liquidity. Our monthly liquidity measure, an average of individual-stock measures estimated with daily data, relies on the principle that order flow induces greater return reversals when liquidity is lower. From 1966 through 1999, the average return on stocks with high sensitivities to liquidity exceeds that for stocks with low sensitivities by 7.5 percent annually, adjusted for exposures to the market return as well as size, value, and momentum factors. Furthermore, a liquidity risk factor accounts for half of the profits to a momentum strategy over the same 34-year period.
This paper examines the contribution of market makers to the liquidity and the efficiency of the options market in a unique setup of an order-driven computerized trading system, in which market makers and other participants operate under equitable conditions. The main findings are: (1) liquidity increased – a 60% increase in trading volume and a 35% decrease of bid–ask spreads; (2) the efficiency of shekel–euro options trading improved – deviations from put–call parity decreased significantly by 12%, and skewness decreased by about 30%. We also find that the net cost to the exchange is out weighted by the benefit to the trading public and that the presence of market makers encouraged trading between other participants far beyond their own trading.
We study the trades of two important classes of market makers, Designated Market Makers (DMMs) and Endogenous Liquidity Providers (ELPs). The former have exchange-assigned obligations to supply liquidity while the latter do so because it is a profitable activity. We compare market maker participation in the cross-section of stocks and under different market conditions and relate the participation decision to trading profits, inventory risk, and capital commitments. Market makers maintain a reliable presence in large stocks when they have no obligation to do so and increase participation when volatility is high. For other stocks, ELP participation is sparse and reflects an active exercise of the option to withdraw when profit opportunities are small or inventory risk is high. DMMs earn relatively smaller profits, assume higher inventory risk, and commit more capital on days with no ELP participation. We show that DMMs reduce execution uncertainty by participating in undesirable trades and serve a fundamental role as providers of immediacy. Our results point to the suitability of a hybrid market structure comprising a limit order book and a DMM to trade less active securities.
We analyze the dynamics of liquidity in Xetra, an electronic open limit order book. We use the Exchange Liquidity Measure (XLM), a measure of the cost of a roundtrip trade of given size V. This measure captures the price and the quantity dimension of liquidity. We present descriptive statistics, analyze the cross-sectional determinants of the XLM measure and document its intraday pattern. Our main contribution is an analysis of the dynamics of the XLM measure around liquidity shocks. We use intraday event study methodology to analyze how a shock affects the XLM measure. We consider two sets of liquidity shocks, large transactions (which are endogenous events because they originate in the market) and Bloomberg ticker news items (which are exogenous events because they originate outside of the market). We find that resiliency after large transactions is high, i.e., liquidity quickly reverts to normal levels. We further document that large trades take place at times when liquidity is unusually high. We interpret this as evidence that large transactions are timed. The Bloomberg ticker news items do not have a discernible effect on liquidity. --
In this paper, we use April 1993 specialist transaction data on 200 NYSE stocks to estimate average specialist gross trading revenues. We define gross trading revenues as the daily change in the specialist's dollar inventory position plus the trade-associated daily change in the specialist's cash position. We estimate that specialist gross trading revenues in the sampled stocks average 970 per stock per day. Positioning losses averaged $300 per stock per day. On average, therefore, about one third of spread revenues go to offset positioning losses. Specialist spread revenues vary by trade size: specialists earn 9 cents per (round-trip) share in spread revenues from small trades and 6 cents per share on larger trades. Finally, we find that specialists trade extensively inside the quoted spread. Only 37 percent of specialist buy trades, for example, take place at the quoted bid; 42 percent occur between the bid and midpoint of the quote and 20 percent occur above the quote midpoint.
A poor liquidity level and a high liquidity risk significantly raise the required return for small-cap stocks. Euronext allows these firms to hire designated market makers (DMMs) who guarantee a minimum liquidity supply for a lump sum annual fee. In an event study based on 74 DMM stocks, we find that the contract improves liquidity level, reduces liquidity risk, and generates an average abnormal return of 3.5%. DMMs participate in more trades and incur a trading loss on high quoted-spread days, i.e., days when their constraint is likely to bind. Finally, DMMs reduce the size of pricing errors.
A poor liquidity level and a high liquidity risk significantly raise the required return for small-cap stocks. Euronext allows these firms to hire designated market makers (DMMs) who guarantee a minimum liquidity supply for a lump sum annual fee. In an event study based on 74 DMM stocks, we find that the contract improves liquidity level, reduces liquidity risk, and generates an average abnormal return of 3.5%. DMMs participate in more trades and incur a trading loss on high quoted-spread days, i.e., days when their constraint is likely to bind. Finally, DMMs reduce the size of pricing errors.
This paper models price formation and order placement strategies in a dynamic centralized limit order market with designated non monopolist market makers. This market design differs from the NYSE and has been adopted by several stock exchanges in Europe and North America mainly for the trading of mid caps. The model is constructed as an extension of Foucault (1999) in order to include market makers who are required to provide two-sided quotes in the book. Traders can place either a market order or a limit order and, in the latter case, they can choose the order's limit price. Comparison between a limit order market with market makers and a pure limit order market yields several testable implications. First, the clearing frequency is higher in a limit order market with designated market makers. Second, the best quotes in the limit order book with market makers are either more or less attractive than in a pure order book depending on whether the best quote has been placed by a trader or a market maker. On an ex ante basis, we find that expected best quotes in the order book can be more or less favourable in the presence of market makers depending on the asset volatility and the differences in valuation among traders. The model thus yields empirical predictions relative to the added value of non monopolist market makers across assets and/or periods. Other things equal, expected best prices in a limit order book with market makers become more attractive than in a pure limit order book when the asset volatility increases. Since asset volatility decreases with equity capitalisation, our results provide a rationale for the trading of mid caps being organized as limit order books with designated dealers. By contrast, the presence of market makers on large capitalisation stock markets could deteriorate market liquidity.
In order to enhance liquidity, Deutsche B¿rse AG postulates that non-actively traded stocks on the electronic limit order platform Xetra contract services of a designated sponsor. Interestingly, a lot of stocks opt for trading with more than one designated liquidity provider. In a first step, this paper provides a panel data assessment of the influence of designated sponsors on quoted and effective spreads. We find that while spreads narrow when trading with one or two designated sponsors, further increases in the number of specialists do not necessarily pay out in terms of higher liquidity. Results are shown to differ both across market segments and across different sponsor firms with spreads being lower for firms contracting brokers. In a second step, the variation in the number of liquidity providers is used to test predictions that link the number of market makers to theoretic components of the bid-ask spread. We provide evidence that the observed spread decline is related to inter-dealer competition and risk sharing, but not necessarily to a decrease in adverse selection costs.
Market orders sent to the NYSE may be executed at prices better than the specialists' quotes. This study investigates the conditions under which this price improvement occurs and whether it is available to everyone or only certain groups. Over 25% of NYSE SuperDot market orders in this study were filled at prices better than the quote, for an average price improvement of approximately $.04 per share. The rate of price improvement increases from about 10 percent with a one-tick spread to around 50 percent with a spread of two ticks or more. "Marketable limit" orders (limit orders with limit prices that could be filled immediately at the current quotes) receivesubstantially less price improvement than market orders, a result not explained by order size. Unlike on the London Stock Exchange, orders placed by individuals get approximately the same or better price improvement than orders placed by brokerage firms or institutions, although index arbitrageurs get less. If hidden SuperDot limit orders were exposed, the rate of price improvement would have decreased about 15 percent.
We examine insider trading in specialist and dealer markets, using the trades of stock brokers who had advance copies of a stock analysis column in Business Week magazine. We find that increases in price and volume occur after informed trades. During informed trading, market makers decrease depth. Depth falls more on the NYSE and Amex than on the Nasdaq. Spreads increase on the NYSE and Amex, but not on the Nasdaq. We find none of these pre-release changes in a nontraded control sample of stocks mentioned in the column. Our results show that insider trading has a negative impact on market liquidity; depth is an important tool to manage asymmetric information risk; and specialist markets are better at detecting informed trades.
Traditional price improvement improperly assesses large orders’ execution quality by ignoring additional liquidity depth-exceeding orders receive at the quoted price and viewing orders that “walk the book” as “disimproved”. Ignoring this additional liquidity is particularly problematic when assessing execution quality in markets with significant non-displayed liquidity. To correct this deficiency, we modify the price benchmark used to determine whether an order is price improved by making the benchmark a function of the order's size relative to the quoted depth. We document that the differences between conventional price improvement and our measure, adjusted price improvement, can be dramatic and show that the difference depends on trading volume, stock price, and volatility.
This paper addresses the issue of the optimal trading system for less actively traded (i.e., ‘thinly-traded’) stocks. We compare the performance of a pure order driven market with limit order book (POD) with that of a hybrid order driven market with specialist and limit order book (HOD). We find that the HOD system offers superior performance along several dimensions of market quality. In particular, the specialist-based system offers lower execution costs, greater depth, a significant increase in the depth-to-spread ratio, and lower adverse selection costs. Very ‘thinly-traded’ stocks benefit more than less inactive stocks from the adoption of a hybrid trading system both in terms of greater liquidity and in terms of lower adverse selection costs.
Specialists compete with limit order traders to provide liquidity at the New York Stock Exchange. Since specialists see all system limit orders, they enjoy a unique advantage in this competition. We examine whether the limit order book is informative about future price changes and whether specialists use this information when trading. We use order quantities as well as option values to capture the information content of the limit order book. Our analyses consider three actions specialists can take when a market order arrives: stop the order, immediately fill the order at the quoted price, or immediately fill the order at an improved price. Using SuperDOT limit orders in the TORQ database, we find that the limit order book is informative about future price movements. We also find that specialists use this information in ways that favor them (and sometimes the floor community) over the limit order traders. The results are more evident for active stocks where the competition between specialists and limit order traders is more intense. Moreover, we find strong evidence that specialists in lower-priced stocks are less likely to initiate such actions because of the large relative tick size.
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.
Using intraday options data, this paper analyzes the “natural experiment” of the Chicago Board Options Exchange (CBOE) superimposing a specialist system on an existing multiple market maker system during 1999. We find support for the demand uncertainty literature which states that specialists are better able to resolve uncertainty about investor preferences. In particular, we find that quoted, current, and effective spreads decrease following the specialist system adoption. This translates into a $221 million annual savings for investors. We further find that following the switch, the market share of the CBOE increases significantly, suggesting that specialists use spreads to attract order flow.
Execution costs, as measured by the quoted spread, the effective spread (which accounts for trades inside the quotes), the realized spread (which measures revenues of suppliers of immediacy), the Roll (1984) implied spread, and the post-trade variability, are twice as large for a sample of NASDAQ stocks as they are for a matched sample of NYSE stocks. The difference is not due to differences in adverse information, in market depth, or in the frequency of even-eighth quotes. Partial explanations are provided by differences in the treatment of limit orders and commissions in the two markets. We conclude that important explanations are the internalization and preferencing of order flow and the presence of alternative interdealer trading systems, factors that limit dealers' incentives to narrow spreads on NASDAQ.
Existing empirical studies provide little support for the theoretical prediction that market makers rebalance their inventory through revisions of quoted prices. This study provides evidence that the NYSE's specialist does engage in significant inventory rebalancing, but only when not constrained by the affirmative obligation to provide liquidity imposed by the Price Continuity rule. The evidence also suggests that such obligations are associated with better market quality, but impose significant costs on the specialist. The specialist mitigates these costs through discretionary trading when the rule is not binding. These findings shed light on how exchange rules affect market makers’ behavior and market quality.
This paper suggests that earnings announcements provide information that allows certain traders to make judgements about a firm's performance that are superior to the judgements of other traders. As a result, there may be more information asymmetry at the time of an announcement than in nonannouncement periods. More information asymmetry implies that bid–ask spreads increase, suggesting that market liquidity decreases at the time of an earnings announcement. Furthermore, informed opinions resulting from public disclosure may lead to an increase in trading volume, despite the reduction in liquidity that accompanies announcements.
This paper solves explicitly a simple equilibrium model with liquidity risk. In our liquidity-adjusted capital asset pricing model, a security's required return depends on its expected liquidity as well as on the covariances of its own return and liquidity with the market return and liquidity. In addition, a persistent negative shock to a security's liquidity results in low contemporaneous returns and high predicted future returns. The model provides a unified framework for understanding the various channels through which liquidity risk may affect asset prices. Our empirical results shed light on the total and relative economic significance of these channels and provide evidence of flight to liquidity.
The proliferation of electronic limit order books operating without dealers raises questions regarding the need for intermediaries with affirmative obligations to maintain markets. We develop a simple model of dealer participation and test it using a sample of less liquid firms that trade on the Paris Bourse. The results indicate that firms with designated dealers exhibit better market quality, and that younger firms, smaller firms, and less volatile firms choose a designated dealer. Around the announcement of dealer introduction, stocks experience an average cumulative abnormal return of nearly 5% that is positively correlated with improvements in liquidity. Overall, these findings emphasize the potential benefits of designing better market structures, even within electronic limit order books, and suggest that purely endogenous liquidity provision may not be optimal for all securities.
The empirical literature suggests that the limit order book contains information that might be used by the specialist to his own advantage. I develop a model where there is a strategic specialist who competes against a limit order book and has information about supply. The presence of a strategic specialist in an imperfectly competitive limit order book market induces non-monotonicity of market indicators with respect to the variance of liquidation value. Moreover, the existence of private information about supply significantly affects market performance as it induces, among other effects, lower market liquidity. Finally, this model suggests another link between Kyle's (1985, 1989) [Kyle, A., 1985. Continuous auctions and insider trading. Econometrica 53, 1315-1336, Kyle, A., 1989. Informed speculators with imperfect competition. Review of Economic Studies 56, 317-356] and Glosten and Milgrom's (1985) [Glosten, L., Milgrom, P., 1985. Bid, ask and transaction prices in a specialist market with heterogeneously informed markets. Journal of Financial Economics 14, 71-100] models by allowing for strategic behaviour of the specialist.
This study investigates whether marketwide liquidity is a state variable important for asset pricing. We find that expected stock returns are related cross-sectionally to the sensitivities of returns to fluctuations in aggregate liquidity. Our monthly liquidity measure, an average of individual-stock measures estimated with daily data, relies on the principle that order flow induces greater return reversals when liquidity is lower. From 1966 through 1999, the average return on stocks with high sensitivities to liquidity exceeds that for stocks with low sensitivities by 7.5 percent annually, adjusted for exposures to the market return as well as size, value, and momentum factors. Furthermore, a liquidity risk factor accounts for half of the profits to a momentum strategy over the same 34-year period.
Trading on private information creates inefficiencies because there is less than optimal risk sharing. This occurs because the response of marketmakers to the existence of traders with private information is to reduce the liquidity of the market. The institution of the monopolist specialist may ease this inefficiency somewhat by increasing the liquidity of the market. While competing marketmakers will expect a zero profit on every trade, the monopolist will average his profits across trades. This implies a more liquid market when there is extensive trading on private information. Copyright 1989 by the University of Chicago.
When a market order arrives, the NYSE specialist can offer a price one tick better than the limit orders on the book and trade
for his own account. Alternatively, the specialist can “stop” the market order, which means he guarantees execution at the
current quote but provides the possibility of price improvement. My model shows that specialists can use stops to sample the
future order flow before making a commitment to trade. I present empirical evidence that both stops and immediate price improvement
impose adverse selection costs on limit order traders.
This article presents a microstructure model of liquidity provision in which a specialist with market power competes against a competitive limit order book. General solutions, comparative statics and examples are provided first with uninformative orders and then when order flows are informative. The model is also used to address two optimal market design issues. The first is the effect of "tick" size--for example, eighths versus decimal pricing--on market liquidity. Institutions trading large blocks have a larger optimal tick size than small retail investors, but both prefer a tick size strictly greater than zero. Second, a hybrid specialist/limit order market (like the NYSE) provides better liquidity to small retail and institutional trades, but a pure limit order market (like the Paris Bourse) may offer better liquidity on mid-size orders. Article published by Oxford University Press on behalf of the Society for Financial Studies in its journal, The Review of Financial Studies.
We develop attractive functional forms and simple quasi-likelihood estimation methods for regression models with a fractional dependent variable. Compared with log-odds type procedures, there is no difficulty in recovering the regression function for the fractional variable, and there is no need to use ad hoc transformations to handle data at the extreme values of zero and one. We also offer some new, robust specification tests by nesting the logit or probit function in a more general functional form. We apply these methods to a data set of employee participation rates in 401(k) pension plans. Copyright 1996 by John Wiley & Sons, Ltd.
This paper gives a new answer to the challenging question raised by Glosten (1994): "Is the electronic order book inevitable?". While the order book enables traders to compete to supply anonymous liquidity, the specialist system enables one to reap the benefits from repeated interaction. We compare a competitive limit order book and a limit order book with a specialist, like the NYSE. Thanks to non-anonymous interaction, mediated by brokers, uninformed investors can obtain good liquidity from the specialist. This, however, creates an adverse selection problem on the limit order book. Market liquidity and social welfare are improved by the specialist if adverse selection is severe and if brokers have long horizon, so that reputation becomes a matter of concern for them. In contrast, if asymmetric information is limited, spreads are wider and utilitarian welfare is lower when the specialist competes with the limit order book than in a pure limit order book market.
By partitioning quoted depth into the specialist's contribution and the limit order book's contribution, the paper investigates whether specialists manage quoted depth to reduce adverse selection risk. The results show that both specialists and limit order traders reduce depth around information events, thereby reducing their exposure to adverse selection costs. Moreover, specialists' quotes may reflect only the limit order book on the side (or sides) of the market where they believe there is a chance of informed trading. Changes in quoted depth are consistent with specialists managing their inventory as well as having knowledge of the stock's future value.
I establish stylized empirical facts about the trading behavior of New York Stock Exchange specialists. Specifically, I look at the effect of future price movements, the specialist's explicit role, and the specialist's inventory levels on specialist trading behavior. The motivation for this empirical study is to infer whether the specialist behaves like an active investor who has an information advantage which he obtains while acting as a broker for other traders. If this were the case, one would expect that the specialist would engage in a profit maximizing strategy, buying low and selling high, which is opposite to the prediction of the traditional inventory model. I find that specialists behave like active investors who seek to buy stocks when prices are low and to sell when prices are high. I also find that when specialists are not performing their trading obligations of being on the opposite side of the market they are in almost 85 percent of their trades, buying low and selling high. The findings of this paper indicate that the NYSE specialist is best represented in theoretical models as a constrained profit maximizing, informed investor rather than as a zero profit trader.
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 --
: This paper provides a detailed analysis of the call auction procedure on the Frankfurt Stock Exchange. Its main contribution is to develop a direct measure of the execution costs in a call auction that is comparable to the bid-ask spread in a continuous market. Applying that measure, we find that transaction costs for small transactions in the call market are lower than the quoted spread in the order book of the continuous market whereas transaction costs for large transactions in the call market are higher than the spread in the continuous market. An analysis of specialist (Makler) participation shows that the Maklers provide a valuable service to the market. On average, they do not earn profits on the positions they take. Their compensation is thus restricted to the commissions they receive. JEL classification: G10 Keywords: Call auctions, transaction costs, bid-ask spread, specialist behavior 1 Introduction Call market trading bears a close resemblance to the textbook Walrasia...
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 presents a transaction-level empirical analysis of the trading activities of New York Stock Exchange specialists. The main findings of the analysis are the following: adjustment lags in inventories vary across stocks and are in some cases as long as one or two months; decomposition of specialist trading profits by trading horizon shows that the principal source of these profits is short term; an analysis of the dynamic relations among inventories, signed order flow, and quote changes suggests that trades in which the specialist participates have a higher immediate impact on the quotes than trades with no specialist participation. Copyright 1993 by American Finance Association.
This paper analyzes the relationship between banks’ divergent strategies toward specialization and diversification of financial activities and their ability to withstand a banking sector crash. We first generate market-based measures of banks’ systemic risk exposures using extreme value analysis. Systemic banking risk is measured as the tail beta, which equals the probability of a sharp decline in a bank’s stock price conditional on a crash in a banking index. Subsequently, the impact of (the correlation between) interest income and the components of non-interest income on this risk measure is assessed. The heterogeneity in extreme bank risk is attributed to differences in the scope of non-traditional banking activities: non-interest generating activities increase banks’ tail beta. In addition, smaller banks and better-capitalized banks are better able to withstand extremely adverse conditions. These relationships are stronger during turbulent times compared to normal economic conditions. Overall, diversifying financial activities under one umbrella institution does not improve banking system stability, which may explain why financial conglomerates trade at a discount.