New Economics Papers
on Market Microstructure
Issue of 2012‒10‒13
six papers chosen by
Thanos Verousis

  1. Optimal Trading Strategies in a Limit Order Market with Imperfect Liquidity By Kovaleva, P.; Iori, G.
  2. Microstructure effect on firm’s volatility risk By Flavia Barsotti; Simona Sanfelici
  3. Limit theorems for non-degenerate U-statistics of continuous semimartingales By Mark Podolskij; Christian Schmidt; Johanna Fasciati Ziegel
  4. Optimal order placement in limit order markets By Rama Cont; Arseniy Kukanov
  5. The Economic Value of Realized Volatility: Using High-Frequency Returns for Option Valuation By Peter Christoffersen; Bruno Feunou; Kris Jacobs; Nour Meddahi
  6. Dynamic markets for lemons : performance, liquidity, and policy intervention By Diego Moreno; John Wooders

  1. By: Kovaleva, P.; Iori, G.
    Abstract: We study the optimal execution strategy of selling a security. In a continuous time diffusion framework, a risk-averse trader faces the choice of selling the security promptly or placing a limit order and hence delaying the transaction in order to sell at a more favorable price. We introduce a random delay parameter, which defers limit order execution and characterizes market liquidity. The distribution of expected time-to-fill of limit orders conforms to the empirically observed exponential distribution of trading times, and its variance decreases with liquidity. We obtain a closed-form solution and demonstrate that the presence of the lag factor linearizes the impact of other market parameters on the optimal limit price. Finally, two more stylized facts are rationalized in our model: the equilibrium bid-ask spread decreases with liquidity, but increases with agents risk aversion.
    Keywords: order submission; execution delay; first passage time; risk aversion; liquidity traders
    Date: 2012
  2. By: Flavia Barsotti (ISFA, University Lyon 1, France); Simona Sanfelici (Dipartimento di Economia, Universita' di Parma)
    Abstract: Equity returns and firm's default probability are strictly interrelated financial measures capturing the credit risk profile of a firm. Following the idea proposed in [20] we use high-frequency equity prices in order to estimate the volatility risk component of a firm within Merton [17] structural model. Differently from [20] we consider a more general framework by introducing market microstructure noise as a direct effect of using noisy high-frequency data and propose the use of non- parametric estimation techniques in order to estimate equity volatility. We conduct a simulation analysis to compare the performance of different non-parametric volatil- ity estimators in their capability of i) filtering out the market microstructure noise, ii) extracting the (unobservable) true underlying asset volatility level, iii) predicting default probabilies calibrated from Merton [17] model.
    Keywords: market microstructure noise, high-frequency data, non-parametric volatility estimation, Merton model, default probabilities, volatility risk
    Date: 2012–10
  3. By: Mark Podolskij (Heidelberg University and CREATES); Christian Schmidt (Heidelberg University); Johanna Fasciati Ziegel (University of Bern)
    Abstract: This paper presents the asymptotic theory for non-degenerate U-statistics of high frequency observations of continuous Itô semimartingales. We prove uniform convergence in probability and show a functional stable central limit theorem for the standardized version of the U-statistic. The limiting process in the central limit theorem turns out to be conditionally Gaussian with mean zero. Finally, we indicate potential statistical applications of our probabilistic results.
    Keywords: High frequency data, Limit theorems, Semimartingales, Stable convergence, U-statistics
    JEL: C10 C13 C14
    Date: 2012–10–02
  4. By: Rama Cont; Arseniy Kukanov
    Abstract: To execute a trade, participants in electronic equity markets may choose to submit limit orders or market orders across various exchanges where a stock is traded. This decision is influenced by the characteristics of the order flow and queue sizes in each limit order book, as well as the structure of transaction fees and rebates across exchanges. We propose a quantitative framework for studying this order placement problem by formulating it as a convex optimization problem. This formulation allows to study how the interplay between the state of order books, the fee structure, order flow properties and preferences of a trader determine the optimal placement decision. In the case of a single exchange, we derive an explicit solution for the optimal split between limit and market orders. For the general problem of order placement across multiple exchanges, we propose a stochastic algorithm for computing the optimal policy and study the sensitivity of the solution to various parameters using a numerical implementation of the algorithm.
    Date: 2012–10
  5. By: Peter Christoffersen; Bruno Feunou; Kris Jacobs; Nour Meddahi
    Abstract: Many studies have documented that daily realized volatility estimates based on intraday returns provide volatility forecasts that are superior to forecasts constructed from daily returns only. We investigate whether these forecasting improvements translate into economic value added. To do so we develop a new class of affine discrete-time option valuation models that use daily returns as well as realized volatility. We derive convenient closed-form option valuation formulas and we assess the option valuation properties using S&P500 return and option data. We find that realized volatility reduces the pricing errors of the benchmark model significantly across moneyness, maturity and volatility levels.
    Keywords: Asset pricing; Econometric and statistical methods
    JEL: G13
    Date: 2012
  6. By: Diego Moreno; John Wooders
    Abstract: The inefficiency of competitive markets for lemons raises fundamental questions about market performance and the role of policy intervention. We study the performance of dynamic markets, and show that when the time horizon is finite decentralized markets perform better and high quality is more liquid than centralized ones. When frictions are small, decentralized markets become completely illiquid at all but the first and the last date. When the time horizon is infinite, decentralized markets yield the static competitive surplus, whereas centralized markets have separating equilibria that yield a greater surplus. Subsidizing low quality or taxing high quality tends to increase surplus in both decentralized and centralized markets.
    Keywords: Decentralized dynamic market for lemons, Adverse selection, Efficiency, Liquidity, Policy intervention
    Date: 2012–09

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