Knowledge that Transforms

It is demonstrated that markets in stock index futures or, more generally, in baskets of securities, provide a preferred trading medium for uninformed liquidity traders who wish to trade portfolios, because adverse selection costs are typically lower in these markets than in markets for individual securities. Thus, an explanation is provided for the immense liquidity and popularity of markets in stock index futures. Implications are also developed for the effect of the introduction of a basket on market liquidity and the informativeness and variability of component security prices, and for the price relationship between the basket and its underlying portfolio. Article published by Oxford University Press on behalf of the Society for Financial Studies in its journal, The Review of Financial Studies.

Stock prices cluster on round fractions. Clustering increases with price level and volatility, and decreases with capitalization and transaction frequency. Clustering is pervasive. Price clustering will occur if traders use discrete price sets to simplify their negotiations. Exchange regulations require that most stocks be traded on eighths. Clustering on larger fractions will occur if traders choose to use discrete price sets based on quarters, halves, or whole numbers. An econometric model of clustering is derived and estimated. Projections from the results suggest that traders would frequently use odd sixteenths when trading low-price stocks, if exchange regulations permitted trading on sixteenths. Article published by Oxford University Press on behalf of the Society for Financial Studies in its journal, The Review of Financial Studies.

We show that time variation in expected returns and/or partial price adjustments lead to a downward bias in previous estimators of both the spread and its components. We introduce a new approach that provides unbiased and efficient estimators of the components of the spread. We find that between 77 and 97 percent of the downward bias in previous spread estimates is caused by time variation in expected returns. More importantly, the adverse-selection component, though significant, accounts for a much smaller proportion (8 to 13 percent) of the quoted spread, at least for small trades, than the proportion (over 40 percent) previously reported in the literature. Order processing costs are the predominant component of quoted spreads.

When a security trades at multiple locations simultaneously, an informed trader has several avenues in which to exploit his private information. The greater the proportion of liquidity trading by “large” traders who can split their trades across markets, the larger is the correlation between volume in different markets and the smaller is the informativeness of prices. We show that one of the markets emerges as the dominant location for trading in that security. When informed traders can use their information for more than one trading period, the timely release of price information by market makers at one location adversely affects the profits informed traders expect to make subsequently at other locations. Market makers, competing to offer the lowest cost of trading at their location, consequently deter informed trading by voluntarily making the price information public and by “cracking down” on insider trading.

This paper investigates the sensitivity of mean-variance(MV)-efficient portfolios to changes in the means of individual assets. When only a budget constraint is imposed on the investment problem, the analytical results indicate that an MV-efficient portfolio’s weights, mean, and variance can be extremely sensitive to changes in asset means. When nonnegativity constraints are also imposed on the problem, the computational results confirm that a positively weighted MV-efficient portfolio’s weights are extremely sensitive to changes in asset means, but the portfolio’s returns are not. A surprisingly small increase in the mean of just one asset drives half the securities from the portfolio. Yet the portfolio’s expected return and standard deviation are virtually unchanged.

We study the stock price distributions that arise when prices follow a diffusion process with a stochastically varying volatility parameter. We use analytic techniques to derive an explicit closed-form solution for the case where volatility is driven by an arithmetic Ornstein–Uhlenbeck (or AR1) process. We then apply our results to two related problems in the finance literature: (i) options pricing in a world of stochastic volatility, and (ii) the relationship between stochastic volatility and the nature of “fat tails” in stock price distributions.

The authors of this article present convincing evidence that opening prices differ from closing prices. Their major empirical finding is that returns that are measured from the opening of the market to the next open have higher variance than returns measured from the close of trade to the next close. This result is also found in Amihud and Mendelson (1987), but this article improves on the Amihud-Mendelson study by using a larger sample and by conducting a number of other tests. What is special about opening prices? The authors argue that the higher volatility of open-to-open returns is due to the strategic behavior of the specialist. The specialist sets the opening price in the call auction market that occurs at the open and is allowed to trade from his own account at this price. The authors suggest that in exploiting his monopoly position, the specialist increases the effective bid-ask...

This article examines the linkages between equity markets. The authors present a detailed analysis of the correlations between roughly coincident returns in different equity markets. They also uncover an intriguing fact: The volatility of the London stock market is higher than usual around the time when the NYSE opens. This may support their contagion theory, which argues that traders in one market draw inferences about shocks to share-price fundamentals from observed price movements in other markets. Even price moves which are not generated by fundamentals can therefore affect many markets. The findings raise two basic questions about the comovements in international equity markets. The first is whether there is any reason to expect the correlations across markets to be stable through time. This article emphasizes that returns on the London, New York, and Tokyo markets were more highly correlated around the market break of October 1987 than in other periods....