New Economics Papers
on Market Microstructure
Issue of 2007‒04‒09
eight papers chosen by
Thanos Verousis

  1. Anatomy of Bid-Ask Spread Empirical Evidence from an Order-driven Market By Ming-Chang Wang; Lon-Ping Zu; Chau-Jung Kuo
  2. The Asymmetry of the Price Impact of Block Trades and the Bid-Ask Spread. Evidence from the London Stock Exchange By Andros Gregoriou
  3. Forecasting Exchange Rate Volatility with High Frequency Data: Is the Euro Different? By Georgios Chortareas; John Nankervis; Ying Jiang
  4. Transaction costs and informational cascades in financial markets - theory and experimental evidence By Marco Cipriani; Antonio Guarino
  5. Order Aggressiveness and Quantity: How Are They Determined in a Limit Order Market? By Ingrid Lo; Stephen G. Sapp
  6. Long Memory and FIGARCH Models for Daily and High Frequency Commodity Prices By Richard T. Baillie; Young-Wook Han; Robert J. Myers; Jeongseok Song
  7. Market based compensation, price informativeness and short-term trading By Riccardo Calcagno; Florian Heider
  8. Real-Time Effects of Central Bank Interventions in the Euro Market By Rasmus Fatum; Jesper Pedersen

  1. By: Ming-Chang Wang (Department of Finance and Banking, Cheng Shiu University); Lon-Ping Zu (Department of Finance and Banking, Shih Chien University); Chau-Jung Kuo (Department of Finance, National Sun Yat-Sen University)
    Abstract: Under fairly basic rationales, this paper provides a more general microstructure model of price quotation in an order driven market. Specifically, as an extension of Handa and Schwartz (1996), we decompose the equilibrium of the bid-ask spread, which is derived as a function of the weighted average of three factors including the different valuation of traders and the expected loss of adverse selection respectively from buyers and sellers, into the implicate components which evolve from the characteristics of traders and market competition. More importantly, we can distinguish the expected loss of adverse selection, which is endogenously formed in our model, between from buyers and from sellers and investigate the key determinants of the expected loss of adverse selection. The numerical tests clearly show the relationships between the spread and all exogenous parameters. Furthermore, the empirical tests using transaction data on all listed shares in TAIEX provide strong support for our model and show that the asset volatility and the probability of informed trading are significantly positively related to the adverse selection costs. Our results indicate that on average the different valuations account for approximately 26.02% of the bid-ask spread, seller’s expected loss of adverse selection account for 36.95% , and buyer’s one account for 37.03%.
    Keywords: Market Microstructure, Order Strategy, Bid-Ask Spread, Adverse Selection Cost, Price Formation, Order Driven Market,
    Date: 2007–02–02
  2. By: Andros Gregoriou (Brunel Business School, Economics and Finance Section, Brunel University)
    Abstract: In this paper we examine the price impact of block trades for FTSE 100 firms over the time period 1998-2004. Resembling previous research we find evidence of an asymmetric price impact between block purchases and sales. We suggest that bid-ask bias may be a new conjecture to the asymmetry in the differences in buyer and seller initiated trades.
    Keywords: Block Trades, Bid-Ask Bias, Asymmetry, Market Microstructure
    JEL: G14
    Date: 2007–02–02
  3. By: Georgios Chortareas (University of Essex); John Nankervis (University of Essex); Ying Jiang (University of Essex)
    Abstract: This paper focuses on forecasting volatility of high frequency Euro exchange rates. Four 15 minute frequency Euro exchange rate series, including Euro/CHF, Euro/GBP, Euro/JPY and Euro/USD, are used to test the forecast performance of six models, including both traditional time series volatility models and the realized volatility model. Besides the normally used regression test and accuracy test, an equal accuracy test, the HLN-DM test, and a superior predictive ability test are also employed in the out-of-sample forecast evaluation. The FIGARCH model is found to be superior in almost all exchange rate series. Although the widely preferred ARFIMA model shows better performance than the traditional daily volatility models, generally speaking, it cannot surpass the FIGARCH model and the intraday GARCH model. Furthermore, the SVX model does not significantly outperform the SV model in the accuracy test, which contradicts the results of some earlier research. The paper confirms the advantage of using high frequency data and modelling the long memory factor. It also analyses the characteristics of Euro exchange rates and compares the test results with the conclusions drawn by previous studies
    Keywords: exchange rates, volatility, euro, high frequency
    JEL: F31 C22
    Date: 2007–02–02
  4. By: Marco Cipriani (Department of Economics, George Washington University, 2121 I Street, N.W., Washington, D.C. 20052, US.); Antonio Guarino (Department of Economics and ELSE, University College, Gower Street, London WCIE 6BT, UK.)
    Abstract: We study the effect of transaction costs (e.g., a trading fee or a transaction tax, like the Tobin tax) on the aggregation of private information in financial markets. We analyze a financial market à la Glosten and Milgrom, in which informed and uninformed traders trade in sequence with a market maker. Traders have to pay a cost in order to trade. We show that, eventually, all informed traders decide not to trade, independently of their private information, i.e., an informational cascade occurs. We replicated our financial market in the laboratory. We found that, in the experiment, informational cascades occur when the theory suggests they should. Nevertheless, the ability of the price to aggregate private information is not significantly affected. JEL Classification: C92, D8, G14.
    Keywords: Informational Cascades, Herd Behavior, Trade Costs, Tobin Tax.
    Date: 2007–03
  5. By: Ingrid Lo; Stephen G. Sapp
    Abstract: Dealers trading in a limit order market must choose both the order aggressiveness and the quantity for their orders. We empirically investigate how dealers jointly make these decisions in the foreign exchange market using a unique simultaneous equations model. The model uses an ordered probit model to account for the discrete nature of order aggressiveness and a censored regression model to capture the clustering of orders placed at the smallest available quantity, $1 million. We find evidence of a clear trade-off between order aggressiveness and quantity: more aggressive orders tend to be smaller in size. The increased competition (demand) suggested by increased depth on the same (opposite) side of the market leads to less (more) aggressive orders in smaller (larger) size. This holds for the depths at both the best and off-best prices, even though off-best depths are not observable to dealers.
    Keywords: Exchange rates; Financial markets
    JEL: G14
    Date: 2007
  6. By: Richard T. Baillie (Michigan State University and Queen Mary, University of London); Young-Wook Han (Hallym University, Chunchon); Robert J. Myers (Michigan State University); Jeongseok Song (Chung-Ang University, Seoul)
    Abstract: Daily futures returns on six important commodities are found to be well described as FIGARCH fractionally integrated volatility processes, with small departures from the martingale in mean property. The paper also analyzes several years of high frequency intra day commodity futures returns and finds very similar long memory in volatility features at this higher frequency level. Semi parametric Local Whittle estimation of the long memory parameter supports the conclusions. Estimating the long memory parameter across many different data sampling frequencies provides consistent estimates of the long memory parameter, suggesting that the series are self-similar. The results have important implications for future empirical work using commodity price and returns data.
    Keywords: Commodity returns, Futures markets, Long memory, FIGARCH
    JEL: C4 C22
    Date: 2007–04
  7. By: Riccardo Calcagno (Tinbergen Institute and Vrije Universiteit Amsterdam, Department of Finance, De Boelelaan 1105, NL-1081HV Amsterdam.); Florian Heider (European Central Bank, Kaiserstrasse 29, 60311 Frankfurt am Main, Germany.)
    Abstract: This paper shows that there is a natural trade-off when designing market based executive compensation. The benefit of market based pay is that the stock price aggregates speculators’ dispersed information and therefore takes a picture of managerial performance before the long-term value of a firm materializes. The cost is that informed speculators’ willingness to trade depends on trading that is unrelated to any information about the firm. Ideally, the CEO should be shielded from shocks that are not informative about his actions. But since information trading is impossible without non-information trading (due to the ”no-trade” theorem), shocks to prices caused by the latter are an unavoidable cost of market based pay. This trade-off generates a number of insights about the impact of market conditions, e.g. liquidity and trading horizons, on optimal market based pay. A more liquid market leads to more market based pay while short-term trading makes it more costly to provide such incentives leading to lower CEO effort and worse firm performance on average. The model is consistent with recent evidence showing that market based CEO incentives vary with market conditions, e.g. bid-ask spreads, the probability of informed trading (PIN) or the dispersion of analysts’ forecasts. JEL Classification: G39, D86, D82.
    Keywords: Executive compensation, moral hazard, liquidity, trading, stock price informativeness.
    Date: 2007–03
  8. By: Rasmus Fatum (University of Alberta); Jesper Pedersen (Department of Economics, University of Copenhagen)
    Abstract: This paper investigates the real-time effects of foreign exchange intervention using official intraday intervention data provided by the Danish central bank. Denmark is currently pursuing an active intervention policy under the provisions of the Exchange Rate Mechanism (ERM II) and intervenes on a discretionary basis when considered necessary. Prior participation in ERM II is a requirement for adoption of the Euro. Therefore, our study is of particular relevance for the new European Union member states that are either currently participating in ERM II or expected to do so at a later date as well as for Denmark. Our analysis employs the two-step weighted least squares estimation procedure of Andersen, Bollerslev, Diebold and Vega (2003) and an array of robustness tests. We find that intervention exerts a statistically and economically significant influence on exchange rate returns when the direction of intervention is consistent with fundamentals and intervention is carried out during a period of high exchange rate volatility. We also show that the exchange rate does not adjust instantaneously to the unannounced and discretionary interventions under study. We conclude that intervention can be an important short-term policy instrument for exchange rate management.
    Keywords: foreign exchange intervention; intraday data; ERM II
    JEL: D53 E58 F31 G15
    Date: 2007–03

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