A model of price discovery and market design : theory and empirical evidence

An essential function of derivative markets is price discovery. A model is proposed to incorporate a comprehensive dynamic interaction between price size coordinates of orders and trades. An example of application of the model and its effect on price discovery is discussed.

A factor analytical approach to price discovery

Existing econometric approaches for studying price discovery presume that the number of markets are small, and their properties become suspect when this restriction is not met. They also require making identifying restrictions and are in many cases not suitable for statistical inference. The current paper takes these shortcomings as a starting point to develop a factor analytical approach that makes use of the cross-sectional variation of the data, yet is very user-friendly in that it does not involve any identifying restrictions or obstacles to inference.

The economic significance of CDS price discovery

© 2015 Springer Science+Business Media New York Between 2005 and 2009, we document evident time-varying credit risk price discovery between the equity and credit default swap (CDS) markets for 174 US non-financial investment-grade firms. We test the economic significance of a simple portfolio strategy that utilizes fluctuation in CDS spreads as a trading signal to set stock positions, conditional on the CDS price discovery status of the reference entities. We show that a conditional portfolio strategy which updates the list of CDS-influenced firms over time, yields a substantively larger realized return net of transaction cost over the unconditional strategy. Furthermore, the conditional strategy’s Sharpe ratio outperforms a series of benchmark portfolios over the same trading period, including buy-and-hold, momentum and dividend yield strategies.

Price discovery and asset pricing

This paper tests the hypothesis that price discovery influences asset pricing. Our innovations are twofold. First, we estimate time-varying price discovery for a large number (21) of Islamic stock portfolios. Second, we test using a predictive regression model whether or not price discovery predicts stock excess returns. We find from both in-sample and out-of-sample tests that all 21 portfolio excess returns are predictable. We show that a mean-variance investor by tracking price discovery is able to devise profitable trading strategies.

Rating downgrade and the price impact of CDS spread on stock return

We investigate the time-varying informativeness of credit default swap (CDS) trading on stock returns for 302 US firms from July 2004 to August 2010. Using the Acharya and Johnson (2007) measure, we find that CDS trading becomes informative for an increasing number of firms as we approach the global financial crisis (GFC). Firm numbers gradually decline post-GFC, but remain high compared to the pre-GFC period. furthermore, CDS trading imposes the largest conditional price impact on firms that are recently downgraded, regardless of rating levels. Interestingly, this holds during and after the GFC, but not before. We offer two implications. First, despite post-GFC outcry against the CDS market, our results suggest it exhibits enhanced price discovery during the GFC. Second, our findings support criticism that, in the lead-up to the GFC, rating agencies are slow in downgrading firms. However, if downgrade decisions made during and after the GFC induce informed trading in the CDS market, this necessarily implies that during the midst of the GFC, rating agencies have got their act together.

Time-varying dependence in the intraday AUS/USD spot market

Using a high-frequency data set of the spot Australian dollar/US dollar this study examines the distribution of quotes and returns across the 24 hour trading "day". Employing statistical methods for measuring long-tenn dependence in time-series we find evidence of time-varying dependence and volatility that aligns with the opening and closing of markets. This variation is attributed to the effects of liquidity and the price-discovery actions of dealers.

The trading dynamics of close-substitute futures markets : evidence of margin policy spillover effects

Volatility spillover is well documented among closely related securities. I investigate the relationship between margin policy and trading dynamics of the Nikkei 225 index futures markets of Osaka Securities Exchange (OSE) and Singapore Exchange (SGX). I find that OSE’s margin policy influences trading dynamics across both markets, although it is the less liquid SGX market that performs price discovery. This suggests that policy markers of close substitute markets should coordinate, or at least communicate policy intentions due to policy spillover. SGX’s market design facilitates price discovery, suggesting that a microstructure framework capable of overcoming the liquidity entry barrier is of interest to any futures exchange contemplating contract proliferation.

Floor trading and screen trading : distinctions for practitioners

The creation of an electronic limit order book is discussed as the basis for distinguishing between the floor trading and screen trading of derivative instruments. Distinguishing between FTP and ETP in terms of market transparency allows investors to contemplate the trade-off between the 2 platforms. Distinguishing between FTP and ETP in terms of memory preservation allows practitioners to contemplate the different experiences when analyzing floor data and screen data. A comparable set of floor and screen data is used to examine the impact on the trading dynamics and price discovery of LIFFE's FTSE 100 index futures market when trading is automated on LIFFE CONNECT. The dynamics in the quote change equation is shortened when moving from the floor to screen sample. Using the model's measure of trade informativeness, it is found that in 4 out of 5 daily sub-samples, screen trades are more than twice as informative as floor trades. Variability within a system of equations is explained more by order size history than trade size history.

Measuring the summary informativeness of orders and trades

Improved preservation of order flow history from the automation of derivative trading platforms suggests that traders are potentially learning from the recent history of both order and trade parameters. Consequently, a model to measure price discovery should encapsulate the dynamic interaction between the price-size coordinates of orders and trades. The Hasbrouck (1991) model is extended to measure the summary informativeness of order size and trade size. The two models are used to test for price discovery improvements in the FTSE 100 index futures market from order flow consolidation post deletion of its E-mini counterpart. The informativeness of trades has declined sharply, while the informativeness of orders has risen significantly in the post deletion sample.

An analysis of sectoral equity and CDS spreads

In this paper, we find that CDS return shocks are important in explaining the forecast error variance of sectoral equity returns for the USA. The CDS return shocks have different effects on equity returns and return volatility in the pre-crisis and crisis periods. It is the post-Lehman crisis period in which the effects of CDS return shocks are the most dominant. Finally, we construct a spillover index and find that it is time-varying and explains a larger share of total forecast error variance of sectoral equity and CDS returns for some sectors than for others.

Investor attention, analyst recommendation revisions, and stock prices

We provide evidence that investors underreact after analysts' recommendation upgrades; however, price reactions are faster after downgrades. We measure individual investors' attention using Google's search volume index. Our findings indicate that, after upgrades, stocks that enjoy greater individual investors' attention underreact significantly more compared to stocks that receive high level of attention from institutional investors. On the other hand, after recommendation downgrades, stocks with higher levels of prior attention from individual investors overreact and show a significantly greater price reversal compared to stocks that received high level of attention from institutional investors. Our results suggest that attentive individual investors may not be rational; hence investor attention and investor sophistication are important for price discovery in the market.

Intraday return predictability, portfolio maximisation, and hedging

We examine whether intraday Chinese return predictability is linked to optimal portfolio holding and hedging. We find that: (1) S&P500 futures returns only predict Chinese spot market returns in up to 5-minute of trading with predictability disappearing at higher frequencies of trade; (2) the portfolio weight is maximised at the 5-minute trading frequency, when predictability is the strongest; and (3) when predictability is the strongest, significantly less shorting of the futures is required to minimise risk when a long position is taken in the Chinese market.