Terrence Hendershott, UC, Berkeley; and Albert Menkveld, VU University Amsterdam
Hendershott and Menkveld study price pressures - that is, price deviations from fundamental values caused by a risk-averse intermediary supplying liquidity to asynchronously arriving investors with idiosyncratic hedging values. In their model, the intermediary uses price pressure to mean-revert costly inventory by trading off the size of the price pressure against the cost of remaining in a risky inventory state. Price pressure is associated with the social cost of lower realization of investor hedging value, because the intermediary's efforts to mean-revert inventory substitutes low-hedge-value investors on the side of the market that reduces the risk of the intermediary's position for high-hedge-value investors on the risk-increasing side. Twelve years of daily New York Stock Exchange (NYSE) intermediary data reveal economically large price pressures and associated social costs. A $100,000 inventory shock causes an average price pressure of 0.28 percent and the average transitory volatility in daily stock returns (average price pressure) is 0.49 percent, with substantially larger price pressure effects in smaller stocks. The aggregate lost hedging gains are estimated to be $60 billion for all NYSE common stocks for the sample period.
Zhiguo He, University of Chicago; and Wei Xiong, Princeton University and NBER
Liquidity and Short-term Debt Crises
He and Xiong examine the role of deteriorating market liquidity in exacerbating debt crises. They extend Leland's structural credit-risk model with two realistic features: illiquid secondary bond markets, and a mix of short-term and long-term bonds in a firm's debt structure. As deteriorating market liquidity pushes down bond prices, it also amplifies the conflict of interest between the debt and equity holders -- to avoid bankruptcy, the equity holders have to absorb all of the short-fall from rolling over maturing bonds at the reduced market values. As a result, the equity holders choose to default at a higher fundamental threshold, even if there is no friction for firms to raise more equity. A greater fraction of short-term debt further exacerbates the debt crisis by forcing the equity holders to realize the rollover loss at a higher frequency. The model here illustrates the financial instability brought by overnight repos, an extreme form of short-term financing, to many financial firms, and provides a new explanation for the widely observed flight-to-quality phenomenon. The authors also examine a tradeoff between short-term debt's cheaper financing cost and higher future bankruptcy cost in determining the firm's optimal debt maturity structure and liquidity management strategy.
Paul Tetlock, Columbia University
Does Public Financial News Resolve Asymmetric Information?
Tetlock tests four predictions from a model in which a firm-specific news story releases previously privately held information, thereby expediting the market's absorption of a persistent liquidity shock. Using the entire Dow Jones archive to measure public news, Tetlock provides evidence consistent with these four predictions: 1) ten-day reversals of daily returns are 38 percent lower on news days; 2) ten-day volume-induced momentum in daily returns exists only on news days for many stocks; 3) the cross-sectional correlation between the absolute value of firms' abnormal returns and abnormal turnover is temporarily higher by 35 percent on news days; and 4) the price impact of order flow is temporarily lower by 4.5 percent on news days. Cross-sectional variation in the results suggests that news resolves more asymmetric information for small stocks and illiquid stocks.
Lawrence Glosten, Columbia University
Welfare Costs of Informed Trade
To address the issue of the welfare costs of informed trade, Glosten constructs a new Glosten-Milgrom type model with elastic uninformed trade. Because uninformed trade is elastic, some of the uninformed choose not to trade -- their idiosyncratic valuation lies within the spread. This lack of trade is a welfare loss, and the model can be used to estimate the magnitude of the loss. Calculations show that the welfare loss tends to be single-peaked in the amount of informed trade, reaching a maximum at an internal point. That is, after some point, the welfare loss is decreasing in the amount of informed trade -- with more informed trade, information gets into prices faster and spreads decline. For short-term information (information likely to be revealed in a short amount of time) the maximum loss occurs at a very high probability of informed trade. That is, the welfare loss is mostly increasing in informed trade. For longer-term information, the maximum occurs at a relatively small probability of informed trade, suggesting that over some range the welfare loss is actually declining in informed trade.
Albert Kyle, University of Maryland; and Anna Obizhaeva, University of Maryland
Market Microstructure Invariants
Kyle and Obizhaeva develop a simple model of market microstructure to generate hypotheses about how market depth, bid-ask spread, and order size vary across stocks. They test their model using a dataset of portfolio transitions containing over 400,000 orders in individual stocks executed during 2001-5. The proposed model assumes that the expected number and size of trades per “trading game" are invariant across stocks and across time. This is in contrast to alternative models that assume that the length of the "trading day" is invariant (for example, equal to precisely one calendar day for all stocks). The model here predicts that for every percent increase in the product of dollar trading volume with return volatility, the price impact of trading one percent of average daily volume increases by one-third of a percent. The authors' regresssion results support this prediction. The model makes similar predictions about effective spreads and sizes of trades. These predictions are also supported statistically by regressions based on portfolio transition data. The proposed model implies simple formulas for price impact and effective spread as functions of observable dollar trading volume and volatility.
Dimitri Vayanos, London School of Economics and NBER; Jiang Wang, MIT and NBER
Liquidity and Asset Prices: A Unified Framework
Vayanos and Wang examine how liquidity and asset prices are affected by the following market imperfections: asymmetric information, participation costs, transaction costs, leverage constraints, non-competitive behavior, and search. Their model has three periods: agents are identical in the first, become heterogeneous and trade in the second, and consume asset payoffs in the third. The authors examine how imperfections in the second period affect different measures of illiquidity, as well as asset prices in the first period. Besides nesting multiple imperfections in a single model, they derive new results on the effects of each imperfection. Their results imply, in particular, that imperfections do not always raise expected returns, and can influence common measures of illiquidity in opposite directions.