Tài liệu ADVANCES IN QUANTITATIVE ANALYSIS OF FINANCE AND ACCOUNTING Essays in Microstructure in

ADVANCES IN QUANTITATIVE ANALYSIS OF

FINANCE AND

ACCOUNTING

Essays in Microstructure in Honor of David K. Whitcomb

Volume 3

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ADVANCES IN QUANTITATIVE ANALYSIS OF

FINANCE AND

ACCOUNTING

Essays in Microstructure in Honor of David K. Whitcomb

Volume 3

Editors

Ivan E. Brick

Rutgers University, USA

Tavy Ronen

Rutgers University, USA

Cheng-Few Lee

Rutgers University, USA

World Scientific

NEW JERSEY . LONDON . SINGAPORE . BEIJING . SHANGHAI . HONG KONG . TAIPET. CHENNAI

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ADVANCES IN QUANTITATIVE ANALYSIS OF FINANCE AND ACCOUNTING

VOLUME 3

Essays in Microstructure in Honor of David K Whitcomb

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Preface to Volume 3

Advances in Quantitative Analysis of Finance and Accounting is an annual

publication designed to disseminate developments in the quantitative analy￾sis of finance and accounting. The publication is a forum for statistical and

quantitative analyses of issues in finance and accounting as well as applica￾tions of quantitative methods to problems in financial management, financial

accounting, and business management. The objective is to promote interaction

between academic research in finance and accounting and applied research in

the financial community and the accounting profession.

This volume contains eleven papers in microstructure. These papers have

been classified into three sections: i) Economics of Limit Orders, ii) Essays on

Liquidity of Market, and iii) Market Rationality. The overall highlight of these

papers can be found in the introduction written by Ivan Brick and Tavy Ronen.

v

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March 14, 2006 15:23 WSPC/B351 content.tex

Contents

Preface to Volume 3 v

Introduction to Volume 3 ix

Ivan E. Brick, Tavy Ronen

List of Contributors xv

Section I — Economics of Limit Orders

Chapter 1 Discriminatory Limit Order Books,

Uniform Price Clearing and Optimality 3

Lawrence R. Glosten

Chapter 2 Electronic Limit Order Books and Market

Resiliency: Theory, Evidence, and Practice 19

Mark Coppejans, Ian Domowitz, Ananth Madhavan

Chapter 3 Notes for a Contingent Claims Theory of Limit

Order Markets 39

Bruce N. Lehmann

Chapter 4 The Option Value of the Limit Order Book 57

Alex Frino, Elvis Jarnecic, Thomas H. McInish

Section II — Essays on Liquidity of Markets

Chapter 5 The Cross Section of Daily Variation in Liquidity 75

Tarun Chordia, Lakshmanan Shivakumar,

Avanidhar Subrahmanyam

vii

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viii Contents

Chapter 6 Intraday Volatility on the NYSE and NASDAQ 111

Daniel G. Weaver

Chapter 7 The Intraday Probability of Informed

Trading on the NYSE 139

Michael A. Goldstein, Bonnie F. Van Ness,

Robert A. Van Ness

Chapter 8 Leases, Seats, and Spreads: The Determinants

of the Returns to Leasing a NYSE Seat 159

Thomas O. Miller, Michael S. Pagano

Chapter 9 Decimalization and Market Quality 175

Robin K. Chou, Wan-Chen Lee

Section III — Market Rationality

Chapter 10 The Importance of Being Conservative:

An Illustration of Natural Selection in a

Futures Market 197

Guo Ying Luo

Chapter 11 Speculative Non-Fundamental Components

in Mature Stock Markets: Do they Exist and

are they Related? 217

Ramaprasad Bhar, A. G. Malliaris

Index 247

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Introduction

Ivan E. Brick and Tavy Ronen

Rutgers University, USA

Once an obscure subfield of finance, Market Microstructure has emerged as

a major stream of finance. In its narrowest sense, microstructure might be

defined as the study of the level and the source of transactions costs associated

with trading. It examines the organizational structure of exchanges and how the

specific market structure enhances the efficiency, transparency and information

dissemination of security trading. In a broader sense, this field has opened

new methods and directions from which to examine pre-existing theories and

puzzles in finance, in both the investments and corporate finance areas. It has

seemingly created the most innovative and popular link between the two areas.

In such, it can be viewed as way of thought, as opposed to a subfield.

A major contribution of microstructure can be seen in the advancement of

our understanding of market efficiency. In particular, we can now use intraday

data to examine the speed of information incorporation into security prices

when major corporate announcements take place. Similarly, our understanding

of asset pricing has been altered with the advent of high frequency data anal￾ysis. Traditional asset pricing models focus on the formation of equilibrium

security prices based upon the moments of distribution of the underlying cash

flows of the security and attribute changes in security prices to changes in infor￾mation structure of the market. In contrast, market microstructure recognizes

that the actual transaction prices and variances do not necessarily equal those

determined by our financial models. Thus, the emphasis of market microstruc￾ture becomes the study of the deviations between the transaction price and the

equilibrium price, with deviations attributed to such factors as liquidity, mar￾ket structure, transaction costs, and inventory-based adjustments. Clearly, the

growing body of research in this field has uncovered and revisited many of our

traditional theories, shedding new light on the interpretation of our markets.

This book is a tribute to the field of microstructure and to David K.

Whitcomb, Professor Emeritus at Rutgers University, who is one of its fore￾most pioneers. Like the field itself, David Whitcomb’s contributions have had

an impact both in their academic rigor and practical applications. His articles

ix

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x Ivan E. Brick & Tavy Ronen

have appeared in The American Economic Review, The International Journal

of Finance, The Journal of Banking and Finance, The Journal of Finance,

The Journal of Financial Economics, The Journal of Financial & Quantitative

Analysis, The Journal of Industrial Economics, The Journal of Money, Credit

& Banking, The Journal of Political Economy, Management Science, and The

Review of Economics and Statistics. He is author of one book, Externalities

and Welfare (Columbia University Press, 1972), and co-author of two others,

The Microstructure of Securities Markets (Prentice-Hall, February 1986), and

Transaction Costs and Institutional Investor Trading Strategy (Salomon Broth￾ers Center for the Study of Financial Institutions Monograph Series, 1988).

Besides his principal research interest in market microstructure, his other

research interests include credit market theory, industrial organization, and

economic theory. He is listed as one of the leading researchers in financial eco￾nomics as measured by citations to his research in leading financial economics

journals over the 25 years — 1974 to 1998 (see Chung, Cox, and Mitchell,

“Citation Patterns in the Finance Literature,” Financial Management, 2001).

Dave Whitcomb served as a faculty member in the Finance and Economics

department at the Rutgers Business School for over 25 years, until he retired in

1999 as Professor Emeritus. Today, he devotes himself to Automated Trading

Desk Inc. (ATD), the “microstructure” company he founded. ATD’s brokerage

subsidiary now trades over 65 million shares per day, mostly in the NASDAQ

market and mostly via fully automated limit orders. Automated Trading Desk

Inc. is the first expert system for fully automated limit order trading of common

stocks. ATD is located in Mt. Pleasant, SC, has 50 full time employees and a

subsidiary broker–dealer firm holding membership in the NASD, and trades

about 65 million shares/day (over 2% of total NASDAQ volume). Whitcomb

won the regional 2001 Entrepreneur of the Year award (sponsored by Ernst &

Young, USA Toda, and NASDAQ) for financial services for the Carolinas.

In October 2002, we (Ivan Brick and Tavy Ronen) and Michael Long orga￾nized a conference at the Rutgers Business School of Rutgers University in

honor of David K. Whitcomb. The conference was sponsored by the Whitcomb

Center for Research in Financial Services. This conference showcased papers

and research conducted by the leading luminaries in the field of microstructure

and drew a broad and illustrious audience of academicians, practitioners and

former students, all who came to pay tribute to David.

This book is a collection of 11 original studies in the field of microstructure,

the first seven of which were presented at the conference in October 2002,

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Introduction xi

across different subareas, and each reflecting the future directions of research.

We have loosely divided the book into three sections: Economics of Limit

Orders, Essays on Liquidity of Markets and Market Rationality.

The first section of the book addresses the important issue of optimal limit

order book structure. This is a central focus of the microstructure literature

today, in part because of the growing use of the limit order book in most major

exchanges and markets, both domestically and internationally, in the trade of

equities, derivatives, bonds, and foreign exchange. The chapters in this book

that examine the optimality of the limit order book, as well as its character￾istics and resulting efficiency all take a different perspective in analyzing this

increasingly popular market mechanism. “Single Price Limit Order Books,

Discriminatory Limit Order Books, and Optimality,” by Lawrence Glosten

establishes that the limit order book is not only inevitable, as suggested by his

earlier paper, “Is the electronic limit order book inevitable?” (Glosten, Journal

of Finance, September 1994), but also optimal in most instances. The analysis

incorporates asymmetric information, inventory related costs and potential liq￾uidity difficulties in the derivation and characterization of the equilibrium. The

paper shows that a Centralized Limit order book is indeed optimal, implying

that if a regulatory authority could choose and protect a single market mecha￾nism, it would most probably choose the limit order book mechanism. Another

interesting result of the paper is that a uniform price clearing mechanism can

never be optimal in a setting where private information is present. The negative

profits that Glosten shows to exist in such an environment are surprising in

light of the fact that opening clearings on most exchanges use a uniform price

procedure.

The second paper in this section, “Electronic Limit Order Books and Mar￾ket Resiliency: Theory, Evidence, and Practice,” by Mark Coppejans, Ian

Domowitz, and Ananth Madhavan further addresses the question of market

design by examining the liquidity provision of electronic limit order books.

This is an important feature for market structure to consider, since despite the

advantages of speed and simplicity attributed to automated auctions, a relevant

concern is whether the lack of designated dealers compromise the consistency

of liquidity levels. This paper develops a theoretical model to predict the impact

of economic shocks on the resiliency of the limit order book system. Resiliency

is defined as the speed with which the market absorbs economic shocks. The

paper uses data from actual trade executions of an automated index futures

market limit order book. While volatility shocks are found to reduce liquidity,

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xii Ivan E. Brick & Tavy Ronen

the liquidity shocks dissipate quickly, implying that the electronic order limit

book system is highly resilient. The policy implications of these findings are

immediate: While trading halts following sharp market movements are desir￾able for efficient price discovery, they need not necessarily be long in duration

to achieve their goal. Further, the results of this paper imply that informed

traders take advantage of the depth reported by electronic limit order books to

break up their trades and thereby minimize price impact of their trades.

The third paper in the limit order book section, “Notes on a Contingent

Claims Theory of Limit Order Valuation” by Bruce Lehmann illustrates that

limit order markets can create windows of opportunity for traders to pocket

arbitrage profits if price priority rules govern order matching. These profits can

be captured by simultaneously writing calls and placing a limit buy order, which

in turn can be seen as a call option on a stock. The investor’s profit is then the

call option premium, assuming frictionless markets. Interestingly, the inclusion

of time priority as a secondary execution rule does not completely eliminate

potential arbitrage profit. This paper illustrates examples in which event time

and calendar time differ but can coincide such as to precede continuous trading

in most equity markets. The economics involve assuming that limit order traders

(as suppliers of liquidity) span desired trading in event time.

In “The Option Value of the Limit Order Book,” by Alex Frino, Elvis

Jarnecic and Thomas H. McInish, the option value of the limit order book

is calculated for a sample of ten actively traded stocks from the Australia Stock

Exchange at 11 a.m. each day. The authors find that the option value of the

limit order book is stable for the 11 a.m. snapshot over the sample period of

September 3 to December 31, 2001. Interestingly, they also find that 33.1% of

the option value of the limit order book is provided at the best ask and 34.7% at

the best bid. Moreover, the paper concludes that the option value of the entire

limit order book is more stable than both the value of an individual limit order

option and the number of shares in the limit order book during that time period.

The second section of the book deals with the liquidity of capital mar￾kets. The first chapter of this section is “The Cross-Section of Daily Varia￾tion in Liquidity,” by Tarun Chordia, Lakshmanan Shivakumar and Avanidhar

Subrahmanyam. This paper analyzes cross-sectional heterogeneity in the time￾series variation of liquidity in equity markets using a broad time series and

cross-section of liquidity data. The authors find that average daily changes

in liquidity exhibit significant heterogeneity in the cross-section; that is, the

liquidity of small firms varies more on a daily basis than that of large firms.

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Introduction xiii

A steady increase in aggregate market liquidity over the past decade is more

strongly manifested in large firms than in small firms. The absolute stock return

is an important determinant of liquidity. Cross-sectional differences in the

resilience of a firm’s liquidity to information shocks are analyzed. The sensitiv￾ity of stock liquidity to absolute stock returns is used as an inverse measure of

this resilience, and the measure is found to exhibit considerable cross-sectional

variation. Firm size, return volatility, institutional holdings, and volume are all

found to be significant cross-sectional determinants of this measure.

In “Intraday Volatility on the NYSE and NASDAQ”, Daniel Weaver exam￾ines differences in intraday volatility between stocks trading on the NYSE and

NASDAQ under stable as well as stressful market conditions. Overall results as

well as results broken down by industry group show that NYSE stocks exhibit

lower volatility than those primarily traded on NASDAQ. Additional analysis

that controls for firm specific factors known to be associated with volatility

does not change the conclusion of the unrestricted results. In short — NYSE

stocks are found to exhibit consistently lower intraday volatility than NAS￾DAQ stocks. This finding is consistent with previous studies and suggests that

a specialist market structure is associated with lower volatility.

The next paper, “The Intraday Probability of Informed Trading on the

NYSE” by Michael Goldstein, Bonnie Van Ness and Robert Van Ness exam￾ines intraday trading patterns for a sample of NYSE stocks during the January

through March 2002 time period. The authors use the Easley, Kiefer, O’Hara

and Paperman (Journal of Finance, 1996) model to infer the probability of

informed trading. The paper establishes that trading activity is positively related

to the probability of informed trading which is most strongly apparent at both

the beginning and the end of the trading period. The authors also document that

the amount of regional trading activity is inversely related to the probability of

informed trading.

Economic theory would suggest that the price of a NYSE seat should equal

the present value of the benefits of being able to trade on the NYSE floor.

Testing this proposition has been difficult, as NYSE seats have been relatively

infrequently traded. However, in 1978, the NYSE has allowed the leasing of

seats, which is the focus of the paper, “Leases, Seats, and Spreads: The Determi￾nants of the Returns to Leasing a NYSE Seat,” by Thomas Miller and Michael

S. Pagano. These authors find that the lease rates for a sample of NYSE lease

rates between 1995 and 2005 are a weighted average of past leasing returns and

a set of fundamental factors, including NYSE quoted spreads, NYSE trading

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xiv Ivan E. Brick & Tavy Ronen

volume and market return. Interestingly, past leasing returns are shown to have

a stronger impact upon current lease returns than do the fundamental factors.

The next chapter, “Decimalization and Market Quality,” by Robin K. Chou

and Wan-Chen Lee examines the impact of decimalization on the liquidity of

stocks traded in the NewYork Stock Exchange. Economic theory would suggest

that liquidity provided by market makers would be a function of the tick size.

By January 29, 2001, all NYSE stocks traded in tick sizes of $0.01. The authors

find that spreads decreased significantly after decimalization, but market depth

and average volume per trade decreases as well. The authors argue that these

results are due to front-runners, traders who offer marginally better prices to

gain priority pushing market makers who are willing to provide greater depth

to the market.

Section 3 of the book devotes itself to the rationality of the market. The

first paper of this section, “The Importance of Being Conservative: An Illus￾tration on Natural Selection in a Futures Market,” Guo Ying Luo presents an

evolutionary model of natural selection, with traders modeled as being pre￾programmed with inherent behavioral rules. Two distinct types of traders are

assumed. A conservative buyer has a lower probability of over-predicting the

spot price than other traders. A conservative seller has a lower probability of

under-predicting the spot price. Guo demonstrates that natural selection will

redistribute wealth from less conservative traders to more conservative traders.

As long as the conservative traders have some positive probability of making an

accurate prediction of the spot price, the presence of these traders will ensure

the convergence to an efficient market.

The final chapter of this section and book is “Speculative Non-Fundamental

Components in Mature Stock Markets: Do They Exist and Are They Related?”

by Ramaprasad Bhar and A. G. Malliaris. The authors assume that rational

(or speculative) bubbles, when prices deviate from fundamental pricing factors

may arise from asset price arbitrage conditions. The authors employ a new

empirical methodology to test for the existence of these bubbles in four mature

markets in the United States, Japan, England, and Germany. The methodology

employed allows for the decomposition of stock prices into fundamental and

non-fundamental factors. The paper finds support for the existence of rational

bubbles and that bubbles in the US create bubbles in the other three markets.

There is however no evidence for reverse causality.

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