New Economics Papers
on Market Microstructure
Issue of 2013‒04‒20
three papers chosen by
Thanos Verousis

  1. Equilibrium Fast Trading By Biais, Bruno; Foucault, Thierry; Moinas, Sophie
  2. Liquidity Misallocation in an Over-The-Counter Market By Shengxing Zhang
  3. Currency Risk and Pricing Kernel Volatility By Christopher Telmer; Batchimeg Sambalaibat; Federico Gavazzoni

  1. By: Biais, Bruno; Foucault, Thierry; Moinas, Sophie
    Abstract: High-speed market connections and information processing improve financial institutions'ability to seize trading opportunities, which raises gains from trade. They also enable fast traders to process information before slow traders, which generates adverse selection. We first analyze trading equilibria for a given level of investment in fast-trading technology and then endogenize this level. Investments can be strategic substitutes or complements. In the latter case, investment waves can arise, where institutions invest in fast-trading technologies just to keep up with the others. When some traders become fast, it increases adverse selection costs for all, i.e., it generates negative externalities. Therefore equilibrium investment can exceed its welfare-maximizing counterpart
    Date: 2013–03
  2. By: Shengxing Zhang (New York University)
    Abstract: We show that the dispersion of private valuation reduces market liquidity and allocative efficiency of a dynamic OTC market. In this decentralized market, traders have time varying and heterogeneous private value over the asset and dealers act as competing mechanism designers. We characterize the optimal liquidity provision with endogenous valuation, outside options and type distributions. Depending on traders' value, liquidity can be distorted in three ways, trade breakdown, trade delay or price distortion. The three distortions coexist in the equilibrium. Trade with small gain breaks down. Trade with intermediate gain is delayed. And trade with large gain faces largest distortion in price. As the dispersion of private valuation increases, price dispersion increases and trade is more likely to be delayed or break down for any type. Welfare loss increases as dispersion of private value increases. Quantitatively, welfare loss from liquidity misallocation could reach 5%.
    Date: 2012
  3. By: Christopher Telmer (Carnegie Mellon University); Batchimeg Sambalaibat (Carnegie Mellon University); Federico Gavazzoni (Carnegie Mellon University)
    Abstract: A basic tenet of lognormal asset pricing models is that a risky currency is associated with a low pricing kernel volatility. Empirical evidence implies that a risky currency is associated with a relatively high interest rate. Taken together, these two statements associate high-interest-rate currencies with low pricing kernel volatility. We document evidence suggesting that the opposite is true. We approximate the volatility of the pricing kernel with the volatility of the short interest rate. We find that, across currencies, relatively high interest rate volatility is associated with relatively high interest rates. This contradicts the prediction of lognormal models. One possible reason is that our approximation of the volatility of the pricing kernel is inadequate. We argue that this is unlikely, in particular for questions involving currencies. We conclude that lognormal models of the pricing kernel are inadequate for explaining currency risk and that future work should place increased emphasis on higher moments.
    Date: 2012

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