Market liquidity. Being able to trade the quantity you want to trade with minimal price impact and minimal costCan measure liquidity for individual stocks and then aggregate across the marketWe can get direct measures:Price impact of tradesTransaction costsTrade sizes. Comparing liquidity. B
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1. Measuring Market Liquidity
2. Market liquidity Being able to trade the quantity you want to trade with minimal price impact and minimal cost
Can measure liquidity for individual stocks and then aggregate across the market
We can get direct measures:
Price impact of trades
3. Comparing liquidity But how do we compare liquidity across stocks? Or within the same stock across time?
Suppose we see the following quoted % spreads
GPS = 15 bps; ANF = 20 bps
Is ANF less liquid? Maybe on this dimension…
Is the specialist for GPS doing a better job?
Depends on the factors that influence the spread.
In order to make relative comparisons of liquidity we need to understand and control for factors that influence spreads.
Note both GPS and ANF are NYSE-listed, so differences in market structure are not an issue in this case.
4. Spreads and Spread Components
5. The bid/ask spread The spread is the price impatient traders pay to immediately buy or sell
The spread is the compensation market makers (MMs) and limit order traders earn for offering liquidity
Understanding spreads, and their drivers, is important to:
Optimize order submission strategies given current market conditions – market vs. limit order strategies
Maximizing dealer profitability
Learning about how changes in market structure should change liquidity
6. Spreads and MMs Spreads are crucial to MM profits
If a monopolist, MMs would set spreads to maximize profits
Spread must be wide enough to cover costs of doing business
Spreads can’t be too wide, or else order flow will be too weak to cover costs
MM profit a function of:
Effective spread earned on their round-trip transactions
Number of round-trip transactions
Losses due to market movements against their inventory positions
7. Spread components
8. Overview of spread components If the spread constitutes all (or the majority) of a market makers revenue, then it needs to cover the costs of doing business
These costs are typically broken into two components:
Transaction Cost (Inventory Cost) Component
Order-Processing Costs (normal business costs)
Adverse Selection Cost Component
Risk due to asymmetric information - MMs will lose on transactions with informed traders.
Note that some economists break spread down into the three components with the pink bullets above.
9. Market Maker Inventories Dealers and Specialists have inventories of stock from which they trade
They can control their inventories by adjusting the aggressiveness of their quotes
If inventory is too low:
May have to bypass profitable trades
May be in violation of capital requirements
To fix: Bid aggressively, ask away from market
Increases probability that MM buys
If inventory is too high:
Position is expensive to finance
At increasing risk to drop in stock price
Specialists rarely (if ever) hedge their positions. Why?
To fix: Ask aggressively, bid away from market
Increases probability that MM sells
10. Inventory Risk MMs gain when markets move with their inventory position, and lose when markets move against their inventory position
Diversifiable inventory risk
Due to firm-specific (unsystematic) events no one can predict
If movements are uncorrelated across stocks, then this risk is diversifiable in the specialist portfolio
Return volatility (idiosyncratic risk) is therefore a factor influencing inventory risk – especially so if the MM is not well-diversified
11. Inventory Risk Non-diversifiable inventory risk
Due to correlated (systematic) adverse market movements on stocks with similar inventory positions
Regardless of diversification of portfolio, systematic market movements can decrease value of MMs inventory
Historical Note: about 1/3rd of NYSE specialist firms were essentially put in bankruptcy after market crash of October 1987.
12. Transaction Cost or Inventory Component of the Spread A component of spread needs to cover:
Risk premium MMs may require for bearing inventory risk
Normal costs of doing business
Cost of capital for assets (inventory)
Office space, utilities, other overhead
This component is sometimes also called the “transitory spread component”
If these were the only costs of market making, equilibrium spread would straddle true value, and we would observe ‘bid ask bounce’ in transaction prices (transitory price changes)
13. Adverse Selection Risk The risk of trading with informed traders
MMs know they always lose when trading against a truly informed trader
When informed traders buy, MM inventory falls, and prices subsequently rise
When informed traders sell, MM inventory rises, and prices subsequently fall
14. How to deal with adverse selection? The best method for the MM to deal with this risk is to adjust quotes such that order flow is two-sided (flowing to both bid and ask equally)
This means the quotes are currently close to what the market believes is the true value
Widen quotes so that order flow and trade is limited on both sides of market (equally)
This limits losses by simply limiting trading
MM’s typically do not try to figure out true fundamental values of securities they trade.
They instead focus on order flow and quote adjustments to make a two-sided market.
15. Adverse selection spread component MM’s adjust quotes based on the probability of informed trade
Greater probability of informed trade, should lead to wider spreads, all else constant
This change in spread due to this risk is called the “adverse selection component” of the spread
This component is sometimes called the ‘permanent spread component’ (as opposed to ‘transitory’)
Top of pg 300
Price changes due to adverse selection do not systematically reverse
Instead, price changes reflect MMs inference of true stock value given the direction of order flow
if done correctly, the sequence of resulting price changes should be random
16. Total Spread (see pg 301) V0 is current value estimate
V0B is estimated value given that next trader is a buyer
V0S is estitmated value given that next trader is a seller
17. Total spread on next trade If trade at t=1 is a buyer:
18. Many studies estimate spread components Econometricians can estimate the size of the components because they predict different price movements
TC component should yield transitory ‘bounce’
Adverse selection component should yield a random walk
Most studies have found the adverse selection component to be more important
19. Some empirical evidence Ho and Macris (1984) find that an option specialist’s quotes are influenced by his inventory position, consistent with inventory-based models of market making.
Glosten and Harris (1988) decompose bid-ask spreads into 2 parts, and find that adverse selection component rises in importance with trade size.
Stoll (1989) decomposes spreads into 3 parts, and finds:
43% Adverse Information Costs
10% Inventory Holding Costs
47% Order Processing Costs
Hasbrouck (1988) using different method, also find significant inventory and adverse selection components, with much stronger adverse selection components
Madhavan and Smidt (1991) use specialist inventory data and also finds a much stronger adverse selection component.
Lin, Sanger, and Booth (1995) further analyze spread components by time of day, trade size, and market venue (see next 2 slides)
20. Some empirical evidence
21. Some empirical evidence
22. Cross-sectional liquidity predictions
23. Some cross-sectional spread predictions Stocks with greater probability of informed trade will have higher spreads and lower liquidity, all else constant.
Stocks whose characteristics make it more difficult to manage inventory will have wider spreads.
What proxies to use?
24. Cross-sectional proxies Volatility
Stocks with greater return volatility (idiosyncratic and systematic) should have greater inventory cost components, all else constant.
Also, greater volatility leads to more uncertainty about estimate of V0
Thus, volatility should also exacerbate asymmetric information problems
25. Cross-sectional proxies Utilitarian Trading Interest
Recall that they trade for reasons unrelated to profit; we often call them ‘liquidity motivated traders’
Stocks with stronger utilitarian trading interest tend to be more actively traded, which in turn,
causes spreads to narrow through competition for immediacy
allows inventories to be more easily adjusted
More opportunities for MM to adjust inventory
causes a dilution of the probability of informed trade in the order flow, lowering the adverse selection component
26. Cross-sectional proxies Size of the firm
Larger firms have more information production
Increase utilitarian interest
Decrease prob of informed trade
Number of analysts
Stocks with more reporting analysts should have lower spreads – again due to information production
Stocks with greater press coverage (good or bad) should have lower spreads – due to information production
Holding size of the firm constant, firms with more business units should have lower spreads due to lower inventory and adverse selection risks
Industry or product age
Firms in ‘old’ industries should be more easily valued than firms in ‘new’ industries
Old firms should be more easily valued, all else constant, lowering adverse selection
Material information releases
Probability of informed trade should increase immediately prior to earnings releases, or other announcements
27. Fragmentation issues? Market fragmentation is the degree that a stock’s order flow is spread across various market centers
How should that alter spreads?
Greater fragmentation might increase competition between traders and lower spreads
Christie and Schultz (1994)…
Greater fragmentation might fail to bring buyers and sellers together, leaving each center with a larger spread than one concentrated trading center might achieve
Seems to be a question that only evidence can answer… we come back to this one next week.
28. Cross-Sectional Prediction Summary Spreads are positively related to:
Spreads are negatively related to:
Number of analysts
Degree of press coverage
Number of business units
29. How do we measure market liquidity?
30. Common liquidity measures Quoted bid-ask spreads
Effective bid-ask spreads
Amihud (2002), others
ILLIQ = Absolute return / dollar volume
PIN – econometric methods of estimating the probability of informed trade
31. Spread comparisons Given that we can imagine what factors influence spreads, we can
compare spreads across firms with different market structures while attempting to hold constant various factors known to influence spreads.
Huang and Stoll, 1996, “A Paired Comparison…”
Bessembinder, 1999, “Trade Execution Costs on NYSE…”
Think about how market design issues influence spreads and liquidity
Coughenour and Deli, 2002, “On the Organizational Form…”
Corwin and Coughenour, 2008, “Limited Attention…”
32. Assignment 1B For same stock, gather Consolidated Quote Data for same day in 2004 and 2009 in Excel
These will be bigger files…
By sorting, eliminate quotes with prices of zero and share quantities of zero
By sorting, eliminate quotes with dollar spread > $5.
These are probably errors
Calculate dollar and percentage quoted spreads for each remaining quote
What is the distribution of each spread across whole day?
What is the distribution of each spread for just Ex=‘N’?
What is the mean spread at each half-hour interval?
What is the Amihud (2002) ILLIQ measure each half-hour?
Absolute return / dollar volume of trade
Need to use both data sets.
See page 2 of his paper linked on webpage (last day of class)