Bias in the Effective Bid-Ask Spread
Awarded the De la Vega Prize 2017
Blog | SSRN
Abstract: The effective spread measured relative to the spread midpoint overstates the true effective spread in markets with discrete prices and elastic liquidity demand. The average bias is 18% for S&P 500 stocks in general, and up to 96% for low-priced stocks. Furthermore, the bias makes venues that charge high fees to liquidity suppliers appear artificially liquid in reports mandated by Rule 605 of the US RegNMS. Order routing decisions based on such data are thus potentially misdirected. The bias differs across investor types, leading non-sophisticated investors to overpay for liquidity. It also affects liquidity timing, price impact, and liquidity-sorted portfolios.
Determinants of Limit Order Cancellations
Coauthored with Petter Dahlström and Lars Nordén
Abstract: We investigate the economic rationale behind limit order cancellations from the perspective of liquidity suppliers. We predict that an order is cancelled whenever its expected revenue no longer exceeds the expected cost and we model how order profitability variation can be determined from changes in the state of the order book and the order queue position. Our empirical evidence supports the predictions in general and for orders submitted by high-frequency trading firms in particular. Consistent with our model approach, we find that order cancellation patterns are more consistent with market making than with liquidity demand strategies.
Call Auction Volatility Extensions
Coauthored with Ester Félez Viñas
Blog | SSRN
Abstract: Volatility extensions in closing auctions are designed to improve the efficiency of the closing price. We hypothesize that the channel for the efficiency increase is that extensions improve market integrity and investor trust in the auction mechanism. We confirm that the introduction of a volatility extension indeed reduces extraordinary closing price volatility, deters market manipulation strategies, and makes the auction more attractive to investors. Our findings provide guidance to policy makers who are due to introduce volatility extensions at NYSE and NASDAQ in 2017. In the European Union, call auction volatility curbs become mandatory under Markets in Financial Instruments Directive II in 2018.
Does Commonality in Illiquidity Matter to Investors?
Coauthored with Richard Anderson, Jane Binner, and Birger Nilsson
Published 2013 as a Federal Reserve Bank of St Louis Working Paper
Abstract: This paper investigates whether investors are compensated for taking on commonality risk in equity portfolios. A large literature documents the existence and the causes of commonality in illiquidity, but the implications for investors are less understood. In a more than fifty year long sample of NYSE stocks, we find that commonality risk carries a return premium of at least 2.0 per cent annually. The commonality risk premium is statistically and economically significant, and substantially higher than what is found in previous studies. It is robust when controlling for illiquidity level effects, transaction costs, as well as variations in illiquidity measurement.