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on Market Microstructure |
| By: | Stephen Fagan; Ramazan Gencay |
| Abstract: | Futures contracts on the New York Mercantile Exchange are the most liquid instruments for trading crude oil, which is the world’s most actively traded physical commodity. Under normal market conditions, traders can easily find counterparties for their trades, resulting in an efficient market with virtually no return predictability. Yet even this extremely liquid instrument suffers from liquidity shocks that induce periods of increased volatility and significant return predictability. This paper identifies an important and recurring cause of these shocks: the accumulation of extreme and opposing positions by the two main trader classes in the market, namely hedgers and speculators. As positions become extreme, approaching their historical limits, counterparties for trades become scarce and prices must adjust to induce trade. These liquidity-induced price adjustments are found to be driven by systematic speculative behaviour and are determined to be significant. |
| Keywords: | Liquidity, Futures Markets, Return Predictability, Volatility, Trader Positions, Directional Realized Volatility, Hedgers, Speculators, Position Bounds |
| JEL: | G0 G1 C1 |
| Date: | 2008–01 |
| URL: | http://d.repec.org/n?u=RePEc:eei:rpaper:eeri_rp_2008_01&r=mst |
| By: | Francis X. Diebold (Department of Economics, University of Pennsylvania); Georg H. Strasser (Department of Economics, Boston College) |
| Abstract: | We argue for incorporating the financial economics of market microstructure into the financial econometrics of asset return volatility estimation. In particular, we use market microstructure theory to derive the cross-correlation function between latent returns and market microstructure noise, which feature prominently in the recent volatility literature. The cross-correlation at zero displacement is typically negative, and cross-correlations at nonzero displacements are positive and decay geometrically. If market makers are sufficiently risk averse, however, the cross-correlation pattern is inverted. Our results are useful for assessing the validity of the frequently-assumed independence of latent price and microstructure noise, for explaining observed crosscorrelation patterns, for predicting as-yet undiscovered patterns, and for making informed conjectures as to improved volatility estimation methods. |
| Keywords: | Realized volatility, Market microstructure theory, High-frequency data, Financial econometrics |
| JEL: | G14 G20 D82 D83 C51 |
| Date: | 2008–10–09 |
| URL: | http://d.repec.org/n?u=RePEc:pen:papers:08-038&r=mst |
| By: | Marco LiCalzi (Department of Applied Mathematics, University of Venice); Lucia Milone (Advanced School of Economics, University of Venice); Paolo Pellizzari (Department of Applied Mathematics, University of Venice) |
| Abstract: | This paper studies the continuous double auction from the point of view of market engineering: we tweak the resampling rule adopted in an often-used version of this exchange protocol to search for an improved design. We assume zero intelligence trading as a lower bound for more robust behavioral rules and look at allocative efficiency, as well as three subordinate performance criteria: mean spread, cancelation rate, and traders' protection. This latter notion measures the ability of a protocol to help traders capture their share of the competitive equilibrium profits. We consider two families of resampling rules and obtain the following results. Full resampling is not necessary to attain high allocative effciency, but fine-tuning the resampling rate is important. The best allocative performances are virtually indistinguishable across the two families. However, if the market designer adds any of the other three criteria as a subordinate goal, then a resampling rule based on using a price band around the best quotes is superior. |
| JEL: | D51 D40 C63 C92 |
| Date: | 2008–10 |
| URL: | http://d.repec.org/n?u=RePEc:vnm:wpaper:168&r=mst |
| By: | Ricardo Ribeiro (STICERD, The London School of Economics and Political Science) |
| Abstract: | The Market in Financial Instruments Directive (MiFID) aims to increase competition and to foster client protection in the European financial market. Among other provisions, it abolishes the concentration rule and challenges the market power of existing trading venues. The directive introduces venue competition in order to achieve better execution and ultimately lower trading costs. In this paper I address the question of whether fostering competition between alternative trading venues alone may or not be able to impact actual competition in the market. I consider two reasons for why it may not: direct network effects together with increasing returns to scale, and post-trading constraints. In particular, I (a) evaluate the actual degree of competition between trading venues, (b) measure the impact of network effects on competition, and lastly (c) assess the barriers to competition induced by post-trading constraints. The results imply that financial intermediaries tend to value liquidity more (than total fees) when deciding where to route a given order for execution - implying that being the incumbent venue translates into a competitive advantage. Furthermore, eliminating the mentioned barriers to competition seems to be associated with a significant decrease (of a similar magnitude) in the asymmetry of the industry. |
| Keywords: | Market Dominance, Network Effects, Financial Trading, Demand, Barriers to Competition |
| JEL: | C13 G10 L11 L84 |
| Date: | 2008–10 |
| URL: | http://d.repec.org/n?u=RePEc:net:wpaper:0835&r=mst |