New Economics Papers
on Market Microstructure
Issue of 2010‒09‒25
six papers chosen by
Thanos Verousis

  1. Tick size and price diffusion By Gabriele La Spada; J. Doyne Farmer; Fabrizio Lillo
  2. Price Jumps in Visegrad Country Stock Markets: An Empirical Analysis By Jan Novotny
  3. The endogenous dynamics of markets: price impact and feedback loops By Jean-Philippe Bouchaud
  4. The information content of high-frequency data for estimating equity return models and forecasting risk By Dobrislav P. Dobrev; Pawel J. Szerszen
  5. Are the intraday effects of central bank intervention on exchange rate spreads asymmetric and state dependent? By Rasmus Fatum; Jesper Pedersen; Peter Norman Sørensen
  6. TBA trading and liquidity in the agency MBS market By James Vickery; Joshua Wright

  1. By: Gabriele La Spada; J. Doyne Farmer; Fabrizio Lillo
    Abstract: A tick size is the smallest increment of a security price. Tick size can affect security price in direct and indirect ways. It is clear that at the shortest time scale on which individual orders are placed the tick size has a major role which affects where limit orders can be placed, the bid-ask spread, etc. This is the realm of market microstructure and in fact there is a vast literature on the role of tick size on market microstructure. However, tick size can also affect price properties at longer time scales, and relatively less is known about the effect of tick size on the statistical properties of prices. The present paper is divided in two parts. In the first we review the effect of tick size change on the market microstructure and the diffusion properties of prices. The second part presents original results obtained by investigating the tick size changes occurring at the New York Stock Exchange (NYSE). We show that tick size change has three effects on price diffusion. First, as already shown in the literature, tick size affects price return distribution at an aggregate time scale. Second, reducing the tick size typically leads to an increase of volatility clustering. We give a possible mechanistic explanation for this effect, but clearly more investigation is needed to understand the origin of this relation. Third, we explicitly show that the ability of the subordination hypothesis in explaining fat tails of returns and volatility clustering is strongly dependent on tick size. While for large tick sizes the subordination hypothesis has significant explanatory power, for small tick sizes we show that subordination is not the main driver of these two important stylized facts of financial market.
    Date: 2010–09
  2. By: Jan Novotny
    Abstract: I empirically study price jumps using high frequency data comprising 5-, 10-, 15- and 30-minute market data on the main indices from the Prague, Warsaw, Budapest and Frankfurt Stock Exchanges for June 2003 to the end of 2008. I use two definitions of price jumps: the price jump index and normalized returns. First, I analyze the distribution of returns to support the presence of jumps. Second, I find that the distributions of the price jump indicators employed are significantly different for positive moves compared with negative moves in all the markets studied. In addition, the comparison of jump distributions across different frequencies and markets suggests a possible relationship with market micro-structure as well as with the composition of investors. In particular, at the Prague Stock Exchange, the lower the frequency, the lower the number of extreme jumps, but this is not so at the other markets. Last but not least, I show that the recent financial crisis caused an overall increase in volatility. However, this was not translated into an increase in the absolute number of jumps.
    Keywords: financial markets; Visegrad region; price jumps.
    JEL: G15 P59
    Date: 2010–08
  3. By: Jean-Philippe Bouchaud (CFM)
    Abstract: We review the evidence that the erratic dynamics of markets is to a large extent of endogenous origin, i.e. determined by the trading activity itself and not due to the rational processing of exogenous news. In order to understand why and how prices move, the joint fluctuations of order flow and liquidity - and the way these impact prices - become the key ingredients. Impact is necessary for private information to be reflected in prices, but by the same token, random fluctuations in order flow necessarily contribute to the volatility of markets. Our thesis is that the latter contribution is in fact dominant, resulting in a decoupling between prices and fundamental values, at least on short to medium time scales. We argue that markets operate in a regime of vanishing revealed liquidity, but large latent liquidity, which would explain their hyper-sensitivity to fluctuations. More precisely, we identify a dangerous feedback loop between bid-ask spread and volatility that may lead to micro-liquidity crises and price jumps. We discuss several other unstable feedback loops that should be relevant to account for market crises: imitation, unwarranted quantitative models, pro-cyclical regulation, etc.
    Date: 2010–09
  4. By: Dobrislav P. Dobrev; Pawel J. Szerszen
    Abstract: We demonstrate that the parameters controlling skewness and kurtosis in popular equity return models estimated at daily frequency can be obtained almost as precisely as if volatility is observable by simply incorporating the strong information content of realized volatility measures extracted from high-frequency data. For this purpose, we introduce asymptotically exact volatility measurement equations in state space form and propose a Bayesian estimation approach. Our highly efficient estimates lead in turn to substantial gains for forecasting various risk measures at horizons ranging from a few days to a few months ahead when taking also into account parameter uncertainty. As a practical rule of thumb, we find that two years of high frequency data often suffice to obtain the same level of precision as twenty years of daily data, thereby making our approach particularly useful in finance applications where only short data samples are available or economically meaningful to use. Moreover, we find that compared to model inference without high-frequency data, our approach largely eliminates underestimation of risk during bad times or overestimation of risk during good times. We assess the attainable improvements in VaR forecast accuracy on simulated data and provide an empirical illustration on stock returns during the financial crisis of 2007-2008.
    Date: 2010
  5. By: Rasmus Fatum; Jesper Pedersen; Peter Norman Sørensen
    Abstract: This paper investigates the intraday effects of unannounced foreign exchange intervention on bid-ask exchange rate spreads using official intraday intervention data provided by the Danish central bank. Our starting point is a simple theoretical model of the bid-ask spread which we use to formulate testable hypotheses regarding how unannounced intervention purchases and intervention sales influence the market asymmetrically. To test these hypotheses we estimate weighted least squares (WLS) time-series models of the intraday bid-ask spread. Our main result is that intervention purchases and sales both exert a significant influence on the exchange rate spread, but in opposite directions: intervention purchases of the smaller currency, on average, reduce the spread while intervention sales, on average, increase the spread. We also show that intervention only affects the exchange rate spread when the state of the market is not abnormally volatile. Our results are consistent with the notion that illiquidity arises when traders fear speculative pressure against the smaller currency and confirms the asymmetry hypothesis of our theoretical model.
    Keywords: Financial markets ; Banks and banking, Central ; Monetary policy ; Foreign exchange rates ; International finance
    Date: 2010
  6. By: James Vickery; Joshua Wright
    Abstract: Most mortgages in the United States are securitized through the agency mortgage-backed-securities (MBS) market. These securities are generally traded on a “to-be-announced,” or TBA, basis. This trading convention significantly improves agency MBS liquidity, leading to lower borrowing costs for households. Evaluation of potential reforms to the U.S. housing finance system should take into account the effects of those reforms on the operation of the TBA market.
    Keywords: Mortgages ; Mortgage-backed securities ; Liquidity (Economics) ; Housing - Finance ; Financial market regulatory reform
    Date: 2010

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