nep-fmk New Economics Papers
on Financial Markets
Issue of 2012‒11‒17
two papers chosen by
Kwang Soo Cheong
Johns Hopkins University

  1. High-Frequency Trading Synchronizes Prices in Financial Markets By Austin Gerig
  2. Approximate hedging problem with transaction costs in stochastic volatility markets By Huu Thai Nguyen; Serguei Pergamenchtchikov

  1. By: Austin Gerig
    Abstract: High-speed computerized trading, often called "high-frequency trading" (HFT), has increased dramatically in financial markets over the last decade. In the US and Europe, it now accounts for nearly one-half of all trades. Although evidence suggests that HFT contributes to the efficiency of markets, there are concerns it also adds to market instability, especially during times of stress. Currently, it is unclear how or why HFT produces these outcomes. In this paper, I use data from NASDAQ to show that HFT synchronizes prices in financial markets, making the values of related securities change contemporaneously. With a model, I demonstrate how price synchronization leads to increased efficiency: prices are more accurate and transaction costs are reduced. During times of stress, however, localized errors quickly propagate through the financial system if safeguards are not in place. In addition, there is potential for HFT to enforce incorrect relationships between securities, making prices more (or less) correlated than economic fundamentals warrant. This research highlights an important role that HFT plays in markets and helps answer several puzzling questions that previously seemed difficult to explain: why HFT is so prevalent, why HFT concentrates in certain securities and largely ignores others, and finally, how HFT can lower transaction costs yet still make profits.
    Date: 2012–11
  2. By: Huu Thai Nguyen (LMRS - Laboratoire de Mathématiques Raphaël Salem - CNRS : UMR6085 - Université de Rouen); Serguei Pergamenchtchikov (LMRS - Laboratoire de Mathématiques Raphaël Salem - CNRS : UMR6085 - Université de Rouen)
    Abstract: This paper investigates the problem of hedging European call options using Leland's strategy in stochastic volatility markets with transaction costs. Introducing a new form for the enlarged volatility in Leland's algorithm, we establish a limit theorem and determine a convergence rate for the hedging error. This provides a suggestion to release the underhedging property pointed out by Kabanov and Safarian (1997). Possibilities to improve the convergence rate and lower the option price inclusive transaction costs are also discussed.
    Keywords: Leland strategy, transaction costs, quantile hedging, limit theorem
    Date: 2012–11–01

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