nep-mst New Economics Papers
on Market Microstructure
Issue of 2017‒08‒27
six papers chosen by
Thanos Verousis

  1. Behind the price: on the role of agent's reflexivity in financial market microstructure By Paolo Barucca; Fabrizio Lillo
  2. Trading Out of Sight: An Analysis of Cross-Trading in Mutual Fund Families By Eisele, Alexander; Nefedova, Tamara; Parise, Gianpaolo; Peijnenburg, Kim
  3. Benchmarking Liquidity Proxies: Accounting for Dynamics and Frequency Issues By Langedijk, Sven; Monokroussos, George; Papanagiotou, Evangelia
  4. Liquidity in the Repo Market By Lucas Marc Fuhrer
  5. Derivatives Pricing with Market Impact and Limit Order Book (Forthcoming in Automatica.)(Revised version of F-385) By Taiga Saito; Akihiko Takahashi
  6. Second order approximations for limit order books By Ulrich Horst; D\"orte Kreher

  1. By: Paolo Barucca; Fabrizio Lillo
    Abstract: In this chapter we review some recent results on the dynamics of price formation in financial markets and its relations with the efficient market hypothesis. Specifically, we present the limit order book mechanism for markets and we introduce the concepts of market impact and order flow, presenting their recently discovered empirical properties and discussing some possible interpretation in terms of agent's strategies. Our analysis confirms that quantitative analysis of data is crucial to validate qualitative hypothesis on investors' behavior in the regulated environment of order placement and to connect these micro-structural behaviors to the properties of the collective dynamics of the system as a whole, such for instance market efficiency. Finally we discuss the relation between some of the described properties and the theory of reflexivity proposing that in the process of price formation positive and negative feedback loops between the cognitive and manipulative function of agents are present.
    Date: 2017–08
  2. By: Eisele, Alexander; Nefedova, Tamara; Parise, Gianpaolo; Peijnenburg, Kim
    Abstract: This paper explores the incentives for mutual funds to trade with sibling funds affiliated with the same group. To this end, we construct a dataset of almost one million equity transactions and compare the pricing of trades crossed internally (cross-trades) with that of twin trades executed with external counterparties. We find that cross-trades are used either to opportunistically reallocate performance among trading funds or to reduce transaction costs for both counterparties. The prevalent incentive depends on the intensity of internal monitoring and the market state. We discuss the implications for the literature on fund performance and the current regulatory debate.
    Keywords: Cross-trades; Monitoring; Mutual fund families; Opaque trading; Performance-shifting
    JEL: G11 G23
    Date: 2017–08
  3. By: Langedijk, Sven (European Commission – JRC); Monokroussos, George (Amazon – Seattle, WA, USA); Papanagiotou, Evangelia (European Commission – JRC)
    Abstract: We revisit a central task of the extant liquidity literature, which is to identify effective measures of liquidity, in the context of sovereign bonds and the new Basel III regulatory framework. We critically assess the influential practice of identifying the best liquidity measures based on monthly correlations by comparing and contrasting correlations between monthly and daily averages of high-frequency benchmarks and low-frequency proxies of liquidity, as well as by examining the coherences between such measures. Furthermore, we propose MIDAS regressions as a way of investigating the bilateral relationships between benchmarks and proxies without averaging out potentially valuable high-frequency information, as is common practice. We conclude that the empirical correlations between benchmarks and proxies in general become weaker as the frequency over which these relationships are examined becomes higher, and that standard practices may lead to misleading conclusions in our context. One implication of our results is that any liquidity measure needs to be assessed against the relevant timeframe for conversion into cash.
    Keywords: Liquidity; Market Microstructure; High-Frequency Data; Sovereign Bonds; Basel III; LCR; MIDAS; Coherence
    JEL: C58 G12 G28
    Date: 2016–12
  4. By: Lucas Marc Fuhrer
    Abstract: This paper examines liquidity in the Swiss franc repurchase (repo) market and assesses its determinants using a proprietary dataset ranging from 2006 to 2016. I find that repo market liquidity has a distinct intraday pattern, with low liquidity in early and late trading hours. Moreover, repo market liquidity is negatively affected by stress in the global financial system and the end of the minimum reserve requirement period if central bank reserves are scarce. Furthermore, I show that with excess central bank reserves in the financial system, quoted volumes in the interbank market get imbalanced towards more cash provider relative to cash taker quotes and the trading volume declines. By estimating liquidity in an interbank repo market and explaining its drivers, this paper contributes to the ongoing debate on repo market functioning.
    Keywords: Repo market, liquidity, central bank reserves, Switzerland.
    JEL: G01 G12 G21
    Date: 2017
  5. By: Taiga Saito (Graduate School of Economics, The University of Tokyo); Akihiko Takahashi (Graduate School of Economics, The University of Tokyo)
    Abstract: This paper investigates derivatives pricing under existence of liquidity costs and market impact for the underlying asset in continuous time. Firstly, we formulate the charge for the liquidity costs and the market impact on the derivatives prices through a stochastic control problem that aims to maximize the mark-to-market value of the portfolio less the quadratic variation multiplied by a risk aversion parameter during the hedging period and the liquidation cost at maturity. Then, we obtain the derivatives price by reduction of this charge from the premium in the Bachelier model. Secondly, we consider a second order semilinear partial differential equation (PDE) of parabolic type associated with the control problem, which is analytically solved or approximated by an asymptotic expansion around a solution to an explicitly solvable nonlinear PDE. Finally, we present numerical examples of the pricing for a variance option and a European call option, and show comparative static analyses.
    Date: 2017–08
  6. By: Ulrich Horst; D\"orte Kreher
    Abstract: In this paper we derive a second order approximation for an infinite dimensional limit order book model, in which the dynamics of the incoming order flow is allowed to depend on the current market price as well as on a volume indicator (e.g. the volume standing at the top of the book). We study the fluctuations of the price and volume process relative to their first order approximation given in ODE-PDE form under two different scaling regimes. In the first case we suppose that price changes are really rare, yielding a constant first order approximation for the price. This leads to a measure valued SDE driven by an infinite dimensional Brownian motion in the second order approximation of the volume process. In the second case we use a slower rescaling rate, which leads to a non-degenerate first order approximation and gives a PDE with random coefficients in the second order approximation for the volume process.
    Date: 2017–08

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