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on Market Microstructure |
| By: | Ricardo Lagos (Economics New York University); Guillaume Rocheteau |
| Abstract: | This paper investigates how the degree of trading frictions in asset markets affects portfolio allocations, asset prices, efficiency, and several measures of liquidity, such as execution delays, bid-ask spreads, and trade volumes. To this end, we generalize the search-theoretic model of financial intermediation of Duffie, Garleanu and Pedersen (2005) to allow for more general preferences and idiosyncratic shock structure, unrestricted portfolio choices, aggregate uncertainty, and entry of financial intermediaries (dealers). Investors are subject to shocks that periodically change their desired asset holdings, and contact dealers to rebalance their portfolios. Investors and dealers are matched bilaterally according to a stochastic, time-consuming process, and the latter have instantaneous access to a competitive (inter-dealer) market for the asset. We study the model with a fixed measure of dealers and show that a steady-state equilibrium exists and is unique. We provide a simple condition on preferences under which a reduction in trading frictions (e.g., a reduction in execution delays) will lead to an increase in the price of the asset. We also study the connection between the volatility of asset prices and the degree of trading frictions. From a normative standpoint, we find that the asset allocation is constrained-inefficient unless investors have all the bargaining power in bilateral negotiations with dealers. We also analyze the model with entry of dealers, thereby endogenizing the extent of the trading frictions. We show that the dealers' entry decision introduces a feedback that can give rise to multiple equilibria, and construct examples. With entry, we find that both the portfolio allocation across investors and the number of dealers are socially inefficient |
| Keywords: | Search, asset markets |
| JEL: | G11 G12 |
| Date: | 2006–12–03 |
| URL: | http://d.repec.org/n?u=RePEc:red:sed006:869&r=mst |
| By: | Bea Canto (Watson Wyatt Brans & Co.); Roman Kräussl (Vrije Universiteit Amsterdam and CFS) |
| Abstract: | This study analyzes the short-term dynamic spillovers between the futures returns on the DAX, the DJ Eurostoxx 50 and the FTSE 100. It also examines whether economic news is one source of international stock return co-movements. In particular, we test whether stock market interdependencies are attributable to reactions of foreign traders to public economic information. Moreover, we analyze whether cross-market linkages remain the same or whether they do increase during periods in which economic news is released in one of the countries. Our main results can be summarized as follows: (i) there are clear short term international dynamic interactions among the European stock futures markets; (ii) foreign economic news affects domestic returns; (iii) futures returns adjust to news immediately; (iv) announcement timing of macroeconomic news matters; (v) stock market dynamic interactions do not increase at the time of the release of economic news; (vi) foreign investors react to the content of the news itself more than to the response of the domestic market to the national news; and (vii) contemporaneous correlation between futures returns changes at the time of macroeconomic releases. |
| Keywords: | Market Microstructure,Stock Market Dynamic Interactions, Macroeconomic News, High Frequency Data, VAR Modeling, Variance Decomposition |
| JEL: | G14 G15 |
| Date: | 2006–12–06 |
| URL: | http://d.repec.org/n?u=RePEc:cfs:cfswop:wp2000625&r=mst |
| By: | Peter C.B. Phillips (Cowles Foundation, Yale University); Jun Yu (Singapore Management University) |
| Abstract: | A model of price determination is proposed that incorporates flat trading features into an efficient price process. The model involves the superposition of a Brownian semimartingale process for the efficient price and a Bernoulli process that determines the extent of flat price trading. A limit theory for the conventional realized volatility (RV) measure of integrated volatility is developed. The results show that RV is still consistent but has an inflated asymptotic variance that depends on the probability of flat trading. Estimated quarticity is similarly affected, so that both the feasible central limit theorem and the inferential framework suggested in Barndorff-Nielson and Shephard (2002) remain valid under flat price trading. |
| Keywords: | Bernoulli process, Brownian semimartingale, Flat trading, Quarticity function, Realized volatility |
| JEL: | C15 G12 |
| Date: | 2007–01 |
| URL: | http://d.repec.org/n?u=RePEc:cwl:cwldpp:1598&r=mst |
| By: | Ross Starr (University of California, San Diego) |
| Abstract: | This paper posits an example of Walrasian general competitive equilibrium in an exchange economy with commodity-pairwise trading posts and transaction costs. Budget balance is enforced for each transaction at each trading post separately. Commodity-denominated bid and ask prices at each post allow the post to cover transaction costs through the bid/ask spread. In the absence of double coincidence of wants, the lower transaction-cost commodity (with the narrowest bid/ask spread) becomes the common medium of exchange, commidty money. Selection of the monetary commodity and adoption of a monetary pattern of trad results from price-guided equilibrium without central direction, fiat, or government |
| Keywords: | Transaction cost, bid/ask spread, money, Arrow-Debreu general equilibrium, |
| Date: | 2006–06–01 |
| URL: | http://d.repec.org/n?u=RePEc:cdl:ucsdec:2005-06r&r=mst |
| By: | Craig Burnside (Department of Economics Duke University); Martin Eichenbaum; Isaac Kleshchelski; Sergio Rebelo |
| Abstract: | Currencies that are at a forward premium tend to depreciate. This `forward premium-depreciation anomaly' represents an egregious deviation from uncovered interest parity. We document the returns to currency speculation strategies that exploit this anomaly. The first strategy, known as the carry trade, is widely used by practitioners. This strategy involves selling currencies forward that are at a forward premium and buying those that are at a forward discount. The second strategy relies on a particular regression to forecast the payoff to selling currencies forward. We show that these strategies yield high Sharpe ratios which are not a compensation for risk. However, these Sharpe ratios do not represent unexploited profit opportunities. In the presence of microstructure frictions, spot and forward exchange rates move against traders as they increase their positions. The resulting `price pressure' drives a wedge between average and marginal Sharpe ratios. We argue that marginal Sharpe ratios are zero even though average Sharpe ratios are positive. We display a simple microstructure model that simultaneously rationalizes `price pressure' and the forward premium-depreciation puzzle. The central feature of this model is that market makers face an adverse selection problem that is less severe when, based on public information, the currency is expected to appreciate |
| Keywords: | uncovered interest parity, BGT regressions, price pressure |
| JEL: | G12 G13 G15 |
| Date: | 2006–12–03 |
| URL: | http://d.repec.org/n?u=RePEc:red:sed006:864&r=mst |
| By: | ROSS STARR |
| Abstract: | General equilibrium is investigated with N commodities traded at N(N − 1)/2 commodity-pairwise trading posts. Bid and ask prices are quoted as commodity rates of exchange. Trade is a resource-using activity undertaken by firms recovering transaction costs through the spread between bid (wholesale) and ask (retail)prices. Budget constraints are enforced at each trading post separately;there is demand for a carrier of value between trading posts,commodity money. Existence of general equilibrium follows from convexity and continuity conditions and technical assumptions assuring boundedness of price ratios. Trade in media of exchange(commodity money) is the difference between gross and net trades. |
| Keywords: | trading post, bid price, ask price, medium of exchange, money, |
| Date: | 2005–08–01 |
| URL: | http://d.repec.org/n?u=RePEc:cdl:ucsdec:2005-07&r=mst |
| By: | Alex Boulatov; Dmitry Livdan (Texas A&M University public) |
| Abstract: | This paper analyzes the equilibrium trading strategies of informed traders in the presence of market closures defined as periodic predictable stops of trading. We construct a dynamic auction model based on rational strategic behavior with asymmetric information across the agents. Empirical evidence indicates that market closures have important impact on the information structure of financial markets, in particular the private information flow. In our model, the insiders repeatedly increase their informational advantage over other agents by receiving private signals about fundamentals when the market is closed. In a continuous-time setting, we solve a dynamic programming problem and derive closed-form solutions for optimal intertemporal strategies of both insiders and the market maker. The key feature of insiders' optimal strategy is that they act strategically by anticipating future market closures. Because of this, even though market closures are periodic, the intertemporal pattern of optimal trading strategies is \textit{not} periodic. This aperiodicity of trading is quite important since while it is a definitive feature of the data, it has been missing from the existing theoretical literature on market closures. In agreement with broad empirical evidence, we obtain a U-shaped pattern of trading volume during the periods when the market is open, superimposed on a U-shaped pattern during the lifetime of the economy, before all information about the asset is revealed |
| Keywords: | strategic trading, imperfect competition, assymetric information |
| JEL: | D43 D82 D83 |
| Date: | 2006–12–03 |
| URL: | http://d.repec.org/n?u=RePEc:red:sed006:44&r=mst |
| By: | Gunduz Caginalp; Vladimira Ilieva |
| Abstract: | Asset market experiments are analyzed by distinguishing, ex post facto, participants who trade on fundamentals versus those who trade on momentum (i.e., buying when the price is rising). The distinction is made when prices are above fundamental value, so that (in each period) those who have more offers than bids (net offerers) are classified as fundamentalists while those who have more bids than offers (net bidders) are defined to be momentum players. By analyzing the data of individual behavior we are able to address a number of key questions regarding bubbles. We find evidence that the cash supply of the momentum traders diminishes and the cash supply of the fundamental traders increases as the bubble forms. This suggests that the bubble is fueled by the cash of the momentum players and the reversal is caused by inadequate cash in their possession. These data are used in conjunction with a difference equation for price dynamics for two groups. The momentum traders exhibit a positive coefficient for price derivatives and a very small negative coefficient for trading based upon the deviation from fundamental value. Surprisingly, however, the fundamental traders, who exhibit a positive coefficient for trading on valuation, also exhibit a significantly positive coefficient for trend based buying. Thus, even those who are net offerers, classified as fundamentalists, are selling less and buying more of overvalued stock when there is a strong positive recent price change. There is also evidence that some fundamentalists change strategy to momentum trading as prices soar. An additional result is that the trend coefficient of the momentum traders vanishes with the implementation of an “open book” that allows traders to see all trades as they are entered. |
| Keywords: | Experimental economics, Asset markets, Behavioral finance, Momentum traders, Fundamental traders |
| JEL: | G12 C90 |
| Date: | 2006–08 |
| URL: | http://d.repec.org/n?u=RePEc:usi:labsit:008&r=mst |
| By: | Peter C.B. Phillips (Cowles Foundation, Yale University); Jun Yu (Singapore Management University) |
| Abstract: | This paper overviews maximum likelihood and Gaussian methods of estimating continuous time models used in finance. Since the exact likelihood can be constructed only in special cases, much attention has been devoted to the development of methods designed to approximate the likelihood. These approaches range from crude Euler-type approximations and higher order stochastic Taylor series expansions to more complex polynomial-based expansions and infill approximations to the likelihood based on a continuous time data record. The methods are discussed, their properties are outlined and their relative finite sample performance compared in a simulation experiment with the nonlinear CIR diffusion model, which is popular in empirical finance. Bias correction methods are also considered and particular attention is given to jackknife and indirect inference estimators. The latter retains the good asymptotic properties of ML estimation while removing finite sample bias. This method demonstrates superior performance in finite samples. |
| Keywords: | Maximum likelihood, Transition density, Discrete sampling, Continuous record, Realized volatility, Bias reduction, Jackknife, Indirect inference |
| JEL: | C22 C32 |
| Date: | 2007–01 |
| URL: | http://d.repec.org/n?u=RePEc:cwl:cwldpp:1597&r=mst |
| By: | Christian Bauer; Sebastian Horlemann |
| Abstract: | Recent approaches in international finance on exchange rates explicitly account for the maturity of interest rates. We integrate the interest parity idea into a modern microstructure model of foreign exchange and national bond markets and develop a model of the term structure of exchange rate expectations. The reaction function of the spot rate on changes of the basic economic variables such as the interest rate is generalized. This capital market model is able to reproduce standard results (e.g. overshooting) without reference to macroeconomic variables like rigid prices. In addition, the semi-elasticity of the spot exchange rate on interest rate changes depends on both the term structure of interest rates in both countries and determinants of the financial markets. The effects of interest rate changes on the spot exchange rate are diminished, if the exchange rate expectations for short and for long horizons have opposite signs. Finally, we show that there are several rational methods of building expectations which are not mutually consistent. This ambiguity of rational expectation building might contribute to explanations of the diversity of empirical results in the literature known as UIP puzzle. |
| Keywords: | exchange rates, expectation, term structure, interest parity |
| JEL: | F31 D84 E43 |
| URL: | http://d.repec.org/n?u=RePEc:uba:hadfwe:termstructure-bauer-horlemann-2006-09&r=mst |