Essays on Market Microstructure: Price Discovery and Informed Trading

Market microstructure is “the study of the trading mechanisms used for financial securities” (Hasbrouck (2007)). It seeks to understand the sources of value and reasons for trade, in a setting with different types of traders, and different private and public information sets. The actual mechanisms of trade are a continually changing object of study. These include continuous markets, auctions, limit order books, dealer markets, or combinations of these operating as a hybrid market. Microstructure also has to allow for the possibility of multiple prices. At any given time an investor may be faced with a multitude of different prices, depending on whether he or she is buying or selling, the quantity he or she wishes to trade, and the required speed for the trade. The price may also depend on the relationship that the trader has with potential counterparties. In this research, I touch upon all of the above issues. I do this by studying three specific areas, all of which have both practical and policy implications. First, I study the role of information in trading and pricing securities in markets with a heterogeneous population of traders, some of whom are informed and some not, and who trade for different private or public reasons. Second, I study the price discovery of stocks in a setting where they are simultaneously traded in more than one market. Third, I make a contribution to the ongoing discussion about market design, i.e. the question of which trading systems and ways of organizing trading are most efficient. A common characteristic throughout my thesis is the use of high frequency datasets, i.e. tick data. These datasets include all trades and quotes in a given security, rather than just the daily closing prices, as in traditional asset pricing literature. This thesis consists of four separate essays. In the first essay I study price discovery for European companies cross-listed in the United States. I also study explanatory variables for differences in price discovery. In my second essay I contribute to earlier research on two issues of broad interest in market microstructure: market transparency and informed trading. I examine the effects of a change to an anonymous market at the OMX Helsinki Stock Exchange. I broaden my focus slightly in the third essay, to include releases of macroeconomic data in the United States. I analyze the effect of these releases on European cross-listed stocks. The fourth and last essay examines the uses of standard methodologies of price discovery analysis in a novel way. Specifically, I study price discovery within one market, between local and foreign traders.

Essays on the Role of Time in Price Discovery (summary section only)

The purpose of this thesis is to examine the role of trade durations in price discovery. The motivation to use trade durations in the study of price discovery is that durations are robust to many microstructure effects that introduce a bias in the measurement of returns volatility. Another motivation to use trade durations in the study of price discovery is that it is difficult to think of economic variables, which really are useful in the determination of the source of volatility at arbitrarily high frequencies. The dissertation contains three essays. In the first essay, the role of trade durations in price discovery is examined with respect to the volatility pattern of stock returns. The theory on volatility is associated with the theory on the information content of trade, dear to the market microstructure theory. The first essay documents that the volatility per transaction is related to the intensity of trade, and a strong relationship between the stochastic process of trade durations and trading variables. In the second essay, the role of trade durations in price discovery is examined with respect to the quantification of risk due to a trading volume of a certain size. The theory on volume is intrinsically associated with the stock volatility pattern. The essay documents that volatility increases, in general, when traders choose to trade with large transactions. In the third essay, the role of trade durations in price discovery is examined with respect to the information content of a trade. The theory on the information content of a trade is associated with the theory on the rate of price revisions in the market. The essay documents that short durations are associated with information. Thus, traders are compensated for responding quickly to information

Essays on Corporate Governance and the Quality of Disclosed Earnings: Across Transitional Europe

A growing body of empirical research examines the structure and effectiveness of corporate governance systems around the world. An important insight from this literature is that corporate governance mechanisms address the excessive use of managerial discretionary powers to get private benefits by expropriating the value of shareholders. One possible way of expropriation is to reduce the quality of disclosed earnings by manipulating the financial statements. This lower quality of earnings should then be reflected by the stock price of firm according to value relevance theorem. Hence, instead of testing the direct effect of corporate governance on the firm’s market value, it is important to understand the causes of the lower quality of accounting earnings. This thesis contributes to the literature by increasing knowledge about the extent of the earnings management – measured as the extent of discretionary accruals in total disclosed earnings - and its determinants across the Transitional European countries. The thesis comprises of three essays of empirical analysis of which first two utilize the data of Russian listed firms whereas the third essay uses data from 10 European economies. More specifically, the first essay adds to existing research connecting earnings management to corporate governance. It testifies the impact of the Russian corporate governance reforms of 2002 on the quality of disclosed earnings in all publicly listed firms. This essay provides empirical evidence of the fact that the desired impact of reforms is not fully substantiated in Russia without proper enforcement. Instead, firm-level factors such as long-term capital investments and compliance with International financial reporting standards (IFRS) determine the quality of the earnings. The result presented in the essay support the notion proposed by Leuz et al. (2003) that the reforms aimed to bring transparency do not correspond to desired results in economies where investor protection is lower and legal enforcement is weak. The second essay focuses on the relationship between the internal-control mechanism such as the types and levels of ownership and the quality of disclosed earnings in Russia. The empirical analysis shows that the controlling shareholders in Russia use their powers to manipulate the reported performance in order to get private benefits of control. Comparatively, firms owned by the State have significantly better quality of disclosed earnings than other controllers such as oligarchs and foreign corporations. Interestingly, market performance of firms controlled by either State or oligarchs is better than widely held firms. The third essay provides useful evidence on the fact that both ownership structures and economic characteristics are important factors in determining the quality of disclosed earnings in three groups of countries in Europe. Evidence suggests that ownership structure is a more important determinant in developed and transparent countries, while economic determinants are important determinants in developing and transitional countries.

Short-term Price Behavior and the Effect of Foreign Investors in Finnish Equity Markets (summary section only)

As globalization and capital free movement has increased, so has interest in the effects of that global money flow, especially during financial crises. The concern has been that large global money flows will affect the pricing of small local markets by causing, in particular, overreaction. The purpose of this thesis is to contribute to the body of work concerning short-term under- and overreaction and the short-term effects of foreign investment flow in the small Finnish equity markets. This thesis also compares foreign execution return to domestic execution return. This study’s results indicate that short-term under- and overreaction occurs in domestic-buy portfolios (domestic net buying) rather than in foreign-buy portfolios. This under- and overreaction, however, is not economically meaningful after controlling for the bid-ask bounce effect. Based on this finding, one can conclude that foreign investors do not have a destabilizing effect in the short-term in the Finnish markets. Foreign activity affects short-term returns. When foreign investors are net buyers (sellers) there are positive (negative) market adjusted returns. Literature related to nationality and institutional effect leads us to expect these kind of results. These foreign flows are persistent at a 5 % to 21 % level and the persistence of foreign buy flow is higher than the foreign sell flow. Foreign daily trading execution is worse than domestic execution. Literature which quantifies foreign investors as liquidity demanders and literature related to front-running leads us to expect poorer foreign execution than domestic execution.

Price Inflation, Unemployment and Devaluations: The Finnish Experience of the 1990s

In this paper I provide some empirical answers to important questions such as the determinants of price inflation and the role of inflation polices. The results indicate that monetary policy is surprisingly impotent as a device for controlling inflation and there is little support that it influences the real variables. The low inflation after the Finnish devaluations in the beginning of 90s is foremost due to a previous imbalance in the labor markets and depressed aggregate demand.

Monetary Policy, Stock Price Misalignments and Macroeconomic Instability

Perhaps the most fundamental prediction of financial theory is that the expected returns on financial assets are determined by the amount of risk contained in their payoffs. Assets with a riskier payoff pattern should provide higher expected returns than assets that are otherwise similar but provide payoffs that contain less risk. Financial theory also predicts that not all types of risks should be compensated with higher expected returns. It is well-known that the asset-specific risk can be diversified away, whereas the systematic component of risk that affects all assets remains even in large portfolios. Thus, the asset-specific risk that the investor can easily get rid of by diversification should not lead to higher expected returns, and only the shared movement of individual asset returns – the sensitivity of these assets to a set of systematic risk factors – should matter for asset pricing. It is within this framework that this thesis is situated. The first essay proposes a new systematic risk factor, hypothesized to be correlated with changes in investor risk aversion, which manages to explain a large fraction of the return variation in the cross-section of stock returns. The second and third essays investigate the pricing of asset-specific risk, uncorrelated with commonly used risk factors, in the cross-section of stock returns. The three essays mentioned above use stock market data from the U.S. The fourth essay presents a new total return stock market index for the Finnish stock market beginning from the opening of the Helsinki Stock Exchange in 1912 and ending in 1969 when other total return indices become available. Because a total return stock market index for the period prior to 1970 has not been available before, academics and stock market participants have not known the historical return that stock market investors in Finland could have achieved on their investments. The new stock market index presented in essay 4 makes it possible, for the first time, to calculate the historical average return on the Finnish stock market and to conduct further studies that require long time-series of data.

Tonically Active Kainate Receptors (tKARs) : A Novel Mechanism Regulating Neuronal Function in the Brain

Fast excitatory transmission between neurons in the central nervous system is mainly mediated by L-glutamate acting on ligand gated (ionotropic) receptors. These are further categorized according to their pharmacological properties to AMPA (2-amino-3-(5-methyl-3-oxo-1,2- oxazol-4-yl)propanoic acid), NMDA (N-Methyl-D-aspartic acid) and kainate (KAR) subclasses. In the rat and the mouse hippocampus, development of glutamatergic transmission is most dynamic during the first postnatal weeks. This coincides with the declining developmental expression of the GluK1 subunit-containing KARs. However, the function of KARs during early development of the brain is poorly understood. The present study reveals novel types of tonically active KARs (hereafter referred to as tKARs) which play a central role in functional development of the hippocampal CA3-CA1 network. The study shows for the first time how concomitant pre- and postsynaptic KAR function contributes to development of CA3-CA1 circuitry by regulating transmitter release and interneuron excitability. Moreover, the tKAR-dependent regulation of transmitter release provides a novel mechanism for silencing and unsilencing early synapses and thus shaping the early synaptic connectivity. The role of GluK1-containing KARs was studied in area CA3 of the neonatal hippocampus. The data demonstrate that presynaptic KARs in excitatory synapses to both pyramidal cells and interneurons are tonically activated by ambient glutamate and that they regulate glutamate release differentially, depending on target cell type. At synapses to pyramidal cells these tKARs inhibit glutamate release in a G-protein dependent manner but in contrast, at synapses to interneurons, tKARs facilitate glutamate release. On the network level these mechanisms act together upregulating activity of GABAergic microcircuits and promoting endogenous hippocampal network oscillations. By virtue of this, tKARs are likely to have an instrumental role in the functional development of the hippocampal circuitry. The next step was to investigate the role of GluK1 -containing receptors in the regulation of interneuron excitability. The spontaneous firing of interneurons in the CA3 stratum lucidum is markedly decreased during development. The shift involves tKARs that inhibit medium-duration afterhyperpolarization (mAHP) in these neurons during the first postnatal week. This promotes burst spiking of interneurons and thereby increases GABAergic activity in the network synergistically with the tKAR-mediated facilitation of their excitatory drive. During development the amplitude of evoked medium afterhyperpolarizing current (ImAHP) is dramatically increased due to decoupling tKAR activation and ImAHP modulation. These changes take place at the same time when the endogeneous network oscillations disappear. These tKAR-driven mechanisms in the CA3 area regulate both GABAergic and glutamatergic transmission and thus gate the feedforward excitatory drive to the area CA1. Here presynaptic tKARs to CA1 pyramidal cells suppress glutamate release and enable strong facilitation in response to high-frequency input. Therefore, CA1 synapses are finely tuned to high-frequency transmission; an activity pattern that is common in neonatal CA3-CA1 circuitry both in vivo and in vitro. The tKAR-regulated release probability acts as a novel presynaptic silencing mechanism that can be unsilenced in response to Hebbian activity. The present results shed new light on the mechanisms modulating the early network activity that paves the way for oscillations lying behind cognitive tasks such as learning and memory. Kainate receptor antagonists are already being developed for therapeutic use for instance against pain and migraine. Because of these modulatory actions, tKARs also represent an attractive candidate for therapeutic treatment of developmentally related complications such as learning disabilities.

Mechanism-based inhibition of CYP2C8 by gemfibrozil in humans : characterisation of time and dose relationships

Drug-drug interactions may cause serious, even fatal clinical consequences. Therefore, it is important to examine the interaction potential of new chemical entities early in drug development. Mechanism-based inhibition is a pharmacokinetic interaction type, which causes irreversible loss of enzyme activity and can therefore lead to unusually profound and long-lasting consequences. The in vitro in vivo extrapolation (IVIVE) of drug-drug interactions caused by mechanism-based inhibition is challenging. Consequently, many of these interactions have remained unrecognised for many years. The concomitant use of the fibrate-class lipid-lowering agent gemfibrozil increases the concentrations of some drugs and their effects markedly. Even fatal cases of rhabdomyolysis occurred in patients administering gemfibrozil and cerivastatin concomitantly. One of the main mechanisms behind this effect is the mechanism-based inhibition of the cytochrome P450 (CYP) 2C8 enzyme by a glucuronide metabolite of gemfibrozil leading to increased cerivastatin concentrations. Although the clinical use of gemfibrozil has clearly decreased during recent years, gemfibrozil is still needed in some special cases. To enable safe use of gemfibrozil concomitantly with other drugs, information concerning the time and dose relationships of CYP2C8 inhibition by gemfibrozil should be known. This work was carried out as four in vivo clinical drug-drug interaction studies to examine the time and dose relationships of the mechanism-based inhibitory effect of gemfibrozil on CYP2C8. The oral antidiabetic drug repaglinide was used as a probe drug for measuring CYP2C8 activity in healthy volunteers. In this work, mechanism-based inhibition of the CYP2C8 enzyme by gemfibrozil was found to occur rapidly in humans. The inhibitory effect developed to its maximum already when repaglinide was given 1-3 h after gemfibrozil intake. In addition, the inhibition was shown to abate slowly. A full recovery of CYP2C8 activity, as measured by repaglinide metabolism, was achieved 96 h after cessation of gemfibrozil treatment. The dose-dependency of the mechanism-based inhibition of CYP2C8 by gemfibrozil was shown for the first time in this work. CYP2C8 activity was halved by a single 30 mg dose of gemfibrozil or by twice daily administration of less than 30 mg of gemfibrozil. Furthermore, CYP2C8 activity was decreased over 90% by a single dose of 900 mg gemfibrozil or twice daily dosing of approximately 100 mg gemfibrozil. In addition, with the application of physiological models to the data obtained in the dose-dependency studies, the major role of mechanism-based inhibition of CYP2C8 in the interaction between gemfibrozil and repaglinide was confirmed. The results of this work enhance the proper use of gemfibrozil and the safety of patients. The information related to time-dependency of CYP2C8 inhibition by gemfibrozil may also give new insights in order to improve the IVIVE of the drug-drug interactions of new chemical entities. The information obtained by this work may be utilised also in the design of clinical drug-drug interaction studies in the future.