Bias in the Effective Bid-Ask Spread
Revise and resubmit at Journal of Financial Economics
Awarded the De la Vega Prize 2017
Blog | SSRN | Internet appendix
Abstract: The effective bid-ask spread measured relative to the spread midpoint overstates the true effective bid-ask spread in markets with discrete prices and elastic liquidity demand. The average bias is 13-20% for S&P 500 stocks in general, depending on the estimator used as benchmark, and up to 97% for low-priced stocks. Cross-sectional bias variation across stocks and trading venues can mislead stock selection and order routing decisions. The bias also undermines liquidity timing and trading performance evaluations, and can lead non-sophisticated investors to overpay for liquidity. To overcome these problems, the paper proposes new estimators of the effective bid-ask spread.
Determinants of Limit Order Cancellations
(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
(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?
(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.