New Economics Papers
on Market Microstructure
Issue of 2011‒02‒05
four papers chosen by
Thanos Verousis

  1. Extreme Returns: The Case of Currencies By Carol Osler; Tanseli Savaser
  2. Price Discovery in Currency Markets By Carol Osler; Alexander Mende; Lukas Menkhoff
  3. Post-MiFID Developments in Equity Market Liquidity By Carole Gresse
  4. Stochastic Market Efficiency By Ole Peters; Alexander Adamou

  1. By: Carol Osler (International Business School, Brandeis University); Tanseli Savaser (Department of Economics, Williams College)
    Abstract: This paper investigates how active price-contingent trading contributes to extreme returns even in the absence of news. Price-contingent trading, which is common across financial markets, includes algorithmic trading, technical trading, and dynamic option hedging. The paper highlights four properties of such trading that increase the frequency of extreme returns, and then estimates the relative of these properties using data from the foreign exchange market. The four key properties we consider are: (1) high kurtosis in the distribution of order sizes; (2) clustering of trades within the day; (3) clustering of trades at certain prices; and (4) positive and negative feedback between trading and returns. Calibrated simulations indicate that interactions among these properties are at least as important as any single one. Among individual properties, the orders’ size distribution and feedback effects have the strongest influence. Price-contingent trading could account for over half of realized excess kurtosis in currency returns.
    Keywords: Crash, Fat Tails,Kurtosis,Exchange Rates,Order Flow,High-Frequency,Microstructure,Jump Process,Value-At-Risk,Risk Management
    JEL: G1 F3
    Date: 2010–11
  2. By: Carol Osler (International Business School, Brandeis University); Alexander Mende (Leibniz Universität); Lukas Menkhoff (Leibniz Universität)
    Abstract: This paper examines the price discovery process in currency markets, basing its analysis on the pivotal distinction between the customer (end-user) market and the interdealer market. It first provides evidence that the price discovery process cannot be based on adverse selection between dealers and end users, as postulated in standard equity-market models, because the spreads dealers quote to their customers are not positively related to a trade’s likely information content. The paper then highlights three hypotheses from the literature – fixed operating costs, market power, and strategic dealing – that may explain the cross-sectional variation in customers spreads. The paper finishes by proposing a price discovery process relevant to liquid two-tier markets and providing preliminary evidence that this process applies to currencies.
    Keywords: Bid-ask spreads, foreign exchange, asymmetric information, microstructure, price discovery, interdealer, inventory, market order, limit order
    JEL: F31 G14 G15
    Date: 2010–06
  3. By: Carole Gresse (DRM - Dauphine Recherches en Management - CNRS : UMR7088 - Université Paris Dauphine - Paris IX)
    Abstract: Based on two samples of non-financial large caps from the FTSE 100 and the CAC 40 and a third sample of non-financial mid caps from the SBF 120, this study looks at four monthly periods to compare market liquidity before and after the entry into effect of MiFID. Over the last monthly period, i.e. September 2009, order-flow fragmentation reached substantial levels in all three samples, although it was less pronounced among the mid caps of the SBF 120. Between 20% and 25% of total volumes on the FTSE 100 and the CAC 40 were traded OTC or internalised. As regards non-internalised regulated order flow, 25% to 30% of volumes in large caps were executed on MTFs outside the primary market, compared with around 17% for mid caps of the SBF 120. Despite the high levels of fragmentation, primary markets continue to dominate the European securities trading landscape, with market share of approximately 70% for regulated volumes in large caps and 80% for mid caps. The primary markets also have good relative price competitiveness. The rise in competition between trading venues has been accompanied by a significant decline in price spreads. This reduction in implicit transaction costs is relatively proportionate to the strength of competition, because it is more marked among large caps than among mid caps. The decline has take place at the cost of reduced depth at best limits. Several points temper this conclusion, however. First, trading volumes fell sharply between October 2007 and September 2009. Next, competition between trading systems combined with the rise of algorithmic trading have resulted in orders being more broken up, such that average transaction size has fallen even more steeply than depth at best limits. The frequency of trading and quote changes has also increased greatly. In such an environment, a static measurement of depth has drawbacks, because the frequency with which the depth is renewed is not captured. Also, the available depth appears to be divided between the most active platforms. Ultimately, increased competition has resulted in a decline in implicit transaction costs. The investors best placed to take advantage are logically those that operate on several platforms through smart order routing systems.
    Keywords: market fragmentation, MiFID, stock market liquidity
    Date: 2010
  4. By: Ole Peters; Alexander Adamou
    Abstract: It is argued that the simple trading strategy of leveraging or deleveraging an investment in the market portfolio cannot outperform the market. Such stochastic market efficiency places strong constraints on the possible stochastic properties of the market. Historical data confirm the hypothesis.
    Date: 2011–01

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