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.

Intensity, productivity and efficiency in agriculture in Finland and implications for N and P fertiliser management

The purpose of this study was to evaluate intensity, productivity and efficiency in agriculture in Finland and show implications for N and P fertiliser management. Environmental concerns relating to agricultural production have been and still are focused on arguments about policies that affect agriculture. These policies constrain production while demand for agricultural products such as food, fibre and energy continuously increase. Therefore the importance of increasing productivity is a great challenge to agriculture. Over the last decades producers have experienced several large changes in the production environment such as the policy reform when Finland joined the EU 1995. Other and market changes occurred with the further EU enlargement with neighbouring countries in 2005 and with the decoupling of supports over the 2006-2007 period. Decreasing prices a decreased number of farmers and decreased profitability in agricultural production have resulted from these changes and constraints and of technological development. It is known that the accession to the EU 1995 would herald changes in agriculture. Especially of interest was how the sudden changes in prices of commodities on especially those of cereals, decreased by 60%, would influence agricultural production. The knowledge of properties of the production function increased in importance as a consequence of price changes. A research on the economic instruments to regulate productions was carried out and combined with earlier studies in paper V. In paper I the objective was to compare two different technologies, the conventional farming and the organic farming, determine differences in productivity and technical efficiency. In addition input specific or environmental efficiencies were analysed. The heterogeneity of agricultural soils and its implications were analysed in article II. In study III the determinants of technical inefficiency were analysed. The aspects and possible effects of the instability in policies due to a partial decoupling of production factors and products were studied in paper IV. Consequently connection between technical efficiency based on the turnover and the sales return was analysed in this study. Simple economic instruments such as fertiliser taxes have a direct effect on fertiliser consumption and indirectly increase the value of organic fertilisers. However, fertiliser taxes, do not fully address the N and P management problems adequately and are therefore not suitable for nutrient management improvements in general. Productivity of organic farms is lower on average than conventional farms and the difference increases when looking at selling returns only. The organic sector needs more research and development on productivity. Livestock density in organic farming increases productivity, however, there is an upper limit to livestock densities on organic farms and therefore nutrient on organic farms are also limited. Soil factors affects phosphorous and nitrogen efficiency. Soils like sand and silt have lower input specific overall efficiency for nutrients N and P. Special attention is needed for the management on these soils. Clay soils and soils with moderate clay content have higher efficiency. Soil heterogeneity is cause for an unavoidable inefficiency in agriculture.

The Impact of Emissions Trading on the Price of Electricity in Nord Pool : Market Power and Price Determination in the Nordic Electricity Market

The objective of this thesis is to find out how dominant firms in a liberalised electricity market will react when they face an increase in the level of costs due to emissions trading, and how this will effect the price of electricity. The Nordic electricity market is chosen as the setting in which to examine the question, since recent studies on the subject suggest that interaction between electricity markets and emissions trading is very much dependent on conditions specific to each market area. There is reason to believe that imperfect competition prevails in the Nordic market, thus the issue is approached through the theory of oligopolistic competition. The generation capacity available at the market, marginal cost of electricity production and seasonal levels of demand form the data based on which the dominant firms are modelled using the Cournot model of competition. The calculations are made for two levels of demand, high and low, and with several values of demand elasticity. The producers are first modelled under no carbon costs and then by adding the cost of carbon dioxide at 20€/t to those technologies subject to carbon regulation. In all cases the situation under perfect competition is determined as a comparison point for the results of the Cournot game. The results imply that the potential for market power does exist on the Nordic market, but the possibility for exercising market power depends on the demand level. In season of high demand the dominant firms may raise the price significantly above competitive levels, and the situation is aggravated when the cost of carbon dioixide is accounted for. Under low demand leves there is no difference between perfect and imperfect competition. The results are highly dependent on the price elasticity of demand.

The effects of the 2004 reduction in the price of alcohol on alcohol-related harm in Finland : A natural experiment based on register data

Changes in alcohol pricing have been documented as inversely associated with changes in consumption and alcohol-related problems. Evidence of the association between price changes and health problems is nevertheless patchy and is based to a large extent on cross-sectional state-level data, or time series of such cross-sectional analyses. Natural experimental studies have been called for. There was a substantial reduction in the price of alcohol in Finland in 2004 due to a reduction in alcohol taxes of one third, on average, and the abolition of duty-free allowances for travellers from the EU. These changes in the Finnish alcohol policy could be considered a natural experiment, which offered a good opportunity to study what happens with regard to alcohol-related problems when prices go down. The present study investigated the effects of this reduction in alcohol prices on (1) alcohol-related and all-cause mortality, and mortality due to cardiovascular diseases, (2) alcohol-related morbidity in terms of hospitalisation, (3) socioeconomic differentials in alcohol-related mortality, and (4) small-area differences in interpersonal violence in the Helsinki Metropolitan area. Differential trends in alcohol-related mortality prior to the price reduction were also analysed. A variety of population-based register data was used in the study. Time-series intervention analysis modelling was applied to monthly aggregations of deaths and hospitalisation for the period 1996-2006. These and other mortality analyses were carried out for men and women aged 15 years and over. Socioeconomic differentials in alcohol-related mortality were assessed on a before/after basis, mortality being followed up in 2001-2003 (before the price reduction) and 2004-2005 (after). Alcohol-related mortality was defined in all the studies on mortality on the basis of information on both underlying and contributory causes of death. Hospitalisation related to alcohol meant that there was a reference to alcohol in the primary diagnosis. Data on interpersonal violence was gathered from 86 administrative small-areas in the Helsinki Metropolitan area and was also assessed on a before/after basis followed up in 2002-2003 and 2004-2005. The statistical methods employed to analyse these data sets included time-series analysis, and Poisson and linear regression. The results of the study indicate that alcohol-related deaths increased substantially among men aged 40-69 years and among women aged 50-69 after the price reduction when trends and seasonal variation were taken into account. The increase was mainly attributable to chronic causes, particularly liver diseases. Mortality due to cardiovascular diseases and all-cause mortality, on the other hand, decreased considerably among the-over-69-year-olds. The increase in alcohol-related mortality in absolute terms among the 30-59-year-olds was largest among the unemployed and early-age pensioners, and those with a low level of education, social class or income. The relative differences in change between the education and social class subgroups were small. The employed and those under the age of 35 did not suffer from increased alcohol-related mortality in the two years following the price reduction. The gap between the age and education groups, which was substantial in the 1980s, thus further broadened. With regard to alcohol-related hospitalisation, there was an increase in both chronic and acute causes among men under the age of 70, and among women in the 50-69-year age group when trends and seasonal variation were taken into account. Alcohol dependence and other alcohol-related mental and behavioural disorders were the largest category in both the total number of chronic hospitalisation and in the increase. There was no increase in the rate of interpersonal violence in the Helsinki Metropolitan area, and even a decrease in domestic violence. There was a significant relationship between the measures of social disadvantage on the area level and interpersonal violence, although the differences in the effects of the price reduction between the different areas were small. The findings of the present study suggest that that a reduction in alcohol prices may lead to a substantial increase in alcohol-related mortality and morbidity. However, large population group differences were observed regarding responsiveness to the price changes. In particular, the less privileged, such as the unemployed, were most sensitive. In contrast, at least in the Finnish context, the younger generations and the employed do not appear to be adversely affected, and those in the older age groups may even benefit from cheaper alcohol in terms of decreased rates of CVD mortality. The results also suggest that reductions in alcohol prices do not necessarily affect interpersonal violence. The population group differences in the effects of the price changes on alcohol-related harm should be acknowledged, and therefore the policy actions should focus on the population subgroups that are primarily responsive to the price reduction.

Combined Tevatron upper limit on gg->H->W+W- and constraints on the Higgs boson mass in fourth-generation fermion models

We combine results from searches by the CDF and D0 collaborations for a standard model Higgs boson (H) in the process gg->H->W+W- in p=pbar collisions at the Fermilab Tevatron Collider at sqrt{s}=1.96 TeV. With 4.8 fb-1 of integrated luminosity analyzed at CDF and 5.4 fb-1 at D0, the 95% Confidence Level upper limit on \sigma(gg->H) x B(H->W+W-) is 1.75 pb at m_H=120 GeV, 0.38 pb at m_H=165 GeV, and 0.83 pb at m_H=200 GeV. Assuming the presence of a fourth sequential generation of fermions with large masses, we exclude at the 95% Confidence Level a standard-model-like Higgs boson with a mass between 131 and 204 GeV.

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

The Relationship Between Liquidity, Trading Activity and Return - Studies of the Finnish and Swedish Stock Markets

Liquidity, or how easy an investment is to buy or sell, is becoming increasingly important for financial market participants. The objective of this dissertation is to contribute to the understanding of how liquidity affects financial markets. The first essays analyze the actions taken by underwriters immediately after listing to improve liquidity of IPO stock. To estimate the impact of underwriter activity on the pricing of the IPOs, the order book during the first weeks of trading in the IPO stock is studied. Evidence of stabilization and liquidity enhancing activities by underwriters is found. The second half of the dissertation is concerned with the daily trading of stocks where liquidity may be impacted by policy issues such as changes in taxes or exchange fees and by opening the access to the markets for foreign investors. The desirability of a transaction tax on securities trading is addressed. An increase in transaction tax is found to cause lower prices and higher volatility. In the last essay the objective is to determine if the liquidity of a security has an impact on the return investors require. The results support the notion that returns are negatively correlated to liquidity.

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.