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.

Modelling and Forecasting Property Rents and Returns (summary section only)

Recently, focus of real estate investment has expanded from the building-specific level to the aggregate portfolio level. The portfolio perspective requires investment analysis for real estate which is comparable with that of other asset classes, such as stocks and bonds. Thus, despite its distinctive features, such as heterogeneity, high unit value, illiquidity and the use of valuations to measure performance, real estate should not be considered in isolation. This means that techniques which are widely used for other assets classes can also be applied to real estate. An important part of investment strategies which support decisions on multi-asset portfolios is identifying the fundamentals of movements in property rents and returns, and predicting them on the basis of these fundamentals. The main objective of this thesis is to find the key drivers and the best methods for modelling and forecasting property rents and returns in markets which have experienced structural changes. The Finnish property market, which is a small European market with structural changes and limited property data, is used as a case study. The findings in the thesis show that is it possible to use modern econometric tools for modelling and forecasting property markets. The thesis consists of an introduction part and four essays. Essays 1 and 3 model Helsinki office rents and returns, and assess the suitability of alternative techniques for forecasting these series. Simple time series techniques are able to account for structural changes in the way markets operate, and thus provide the best forecasting tool. Theory-based econometric models, in particular error correction models, which are constrained by long-run information, are better for explaining past movements in rents and returns than for predicting their future movements. Essay 2 proceeds by examining the key drivers of rent movements for several property types in a number of Finnish property markets. The essay shows that commercial rents in local markets can be modelled using national macroeconomic variables and a panel approach. Finally, Essay 4 investigates whether forecasting models can be improved by accounting for asymmetric responses of office returns to the business cycle. The essay finds that the forecast performance of time series models can be improved by introducing asymmetries, and the improvement is sufficient to justify the extra computational time and effort associated with the application of these techniques.

Essays on Risk Modeling. Applications to Portfolio and Risk Management (summary section only)

In this thesis we deal with the concept of risk. The objective is to bring together and conclude on some normative information regarding quantitative portfolio management and risk assessment. The first essay concentrates on return dependency. We propose an algorithm for classifying markets into rising and falling. Given the algorithm, we derive a statistic: the Trend Switch Probability, for detection of long-term return dependency in the first moment. The empirical results suggest that the Trend Switch Probability is robust over various volatility specifications. The serial dependency in bear and bull markets behaves however differently. It is strongly positive in rising market whereas in bear markets it is closer to a random walk. Realized volatility, a technique for estimating volatility from high frequency data, is investigated in essays two and three. In the second essay we find, when measuring realized variance on a set of German stocks, that the second moment dependency structure is highly unstable and changes randomly. Results also suggest that volatility is non-stationary from time to time. In the third essay we examine the impact from market microstructure on the error between estimated realized volatility and the volatility of the underlying process. With simulation-based techniques we show that autocorrelation in returns leads to biased variance estimates and that lower sampling frequency and non-constant volatility increases the error variation between the estimated variance and the variance of the underlying process. From these essays we can conclude that volatility is not easily estimated, even from high frequency data. It is neither very well behaved in terms of stability nor dependency over time. Based on these observations, we would recommend the use of simple, transparent methods that are likely to be more robust over differing volatility regimes than models with a complex parameter universe. In analyzing long-term return dependency in the first moment we find that the Trend Switch Probability is a robust estimator. This is an interesting area for further research, with important implications for active asset allocation.

Essays on Financial Analyst Forecasts and Recommendations

The trade of the financial analyst is currently a much-debated issue in today’s media. As a large part of the investment analysis is conducted under the broker firms’ regime, the incentives of the financial analyst and the investor do not always align. The broker firm’s commercial incentives may be to maximise its commission from securities trading and underwriting fees. The purpose of this thesis is to extend our understanding of the work of a financial analyst, the incentives he faces and how these affect his actions. The first essay investigates how the economic significance of the coverage of a particular firm impacts the analysts’ accuracy of estimation. The hypothesis is that analysts put more effort in analysing firms with a relatively higher trading volume, as these firms usually yield higher commissions. The second essay investigates how analysts interpret new financial statement information. The essay shows that analysts underreact or overreact to prior reported earnings, depending on the short-term pattern in reported earnings. The third essay investigates the possible investment value in Finnish stock recommendations, issued by sell side analysts. It is established that consensus recommendations issued on Finnish stocks contain investment value. Further, the investment value in consensus recommendations improves significantly through the exclusion of recommendations issued by banks. The fourth essay investigates investors’ behaviour prior to financial analysts’ earnings forecast revisions. Lately, the financial press have reported cases were financial analysts warn their preferred clients of possible earnings forecast revisions. However, in the light of the empirical results, it appears that the problem of analysts leaking information to some selected customers does not appear systematically on the Finnish stock market.

Three Essays on the Volatility of Finnish Stock Returns (summary section only)

First, in Essay 1, we test whether it is possible to forecast Finnish Options Index return volatility by examining the out-of-sample predictive ability of several common volatility models with alternative well-known methods; and find additional evidence for the predictability of volatility and for the superiority of the more complicated models over the simpler ones. Secondly, in Essay 2, the aggregated volatility of stocks listed on the Helsinki Stock Exchange is decomposed into a market, industry-and firm-level component, and it is found that firm-level (i.e., idiosyncratic) volatility has increased in time, is more substantial than the two former, predicts GDP growth, moves countercyclically and as well as the other components is persistent. Thirdly, in Essay 3, we are among the first in the literature to seek for firm-specific determinants of idiosyncratic volatility in a multivariate setting, and find for the cross-section of stocks listed on the Helsinki Stock Exchange that industrial focus, trading volume, and block ownership, are positively associated with idiosyncratic volatility estimates––obtained from both the CAPM and the Fama and French three-factor model with local and international benchmark portfolios––whereas a negative relation holds between firm age as well as size and idiosyncratic volatility.

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.

Perceived Value of Mobile Service Use and its Consequences

The thesis is positioned in the services marketing field. Previous mobile service research has identified perceived value or relative advantage as a stable predictor of use of services. However, a more detailed view of what customers value in mobile services is needed for marketing diverse types of mobile content and attracting committed customers. The direct relationships between multidimensional value and loyalty constructs have received limited attention in the previous literature, although a multidimensional view is needed for differentiating services. This thesis studies how perceived value of mobile service use affects customer commitment, repurchase intentions, word-of-mouth and willingness to pay. The doctoral thesis consists of three journal articles and one working paper. The four papers have different sub-aims and comprise individual empirical studies. Mixed methods including both personal interviews and survey data collected from end-users of different types of mobile content services are used. The conceptual mobile perceived value model that results from the first explorative empirical study supports a six- dimensional value view. The six dimensions are further categorized into two higher order constructs: content-related perceived value (emotional, social, convenience and monetary value) and context-related (epistemic and conditional value) perceived value. Structural equation modeling is used in the other three studies to validate this framework by analyzing the relationships between context- and content-related value, and how the individual perceived value dimensions affect commitment and behavioral outcomes. Analyzing the direct relationships revealed differences in the effect of perceived value dimensions between information and entertainment mobile service user groups, between effects on commitment, repurchase intentions and word-of-mouth intentions, as well as between effects on commitment to the provider and to the mobile channel as such. This thesis contributes to earlier perceived value literature by structuring the value dimensions into two groups. Most importantly, the thesis contributes to the value and loyalty literature by increasing understanding of how the different dimensions of perceived value directly affect commitment and post-purchase intentions. The results have implications for further theory development in the electronic services field using multidimensional latent constructs, and practical implications for enhancing commitment to content provider and for differentiated marketing strategies in the mobile field. The general conclusion of this thesis is that differentiated value-based marketing of mobile services is essential for attracting committed customers who will use the same providers’ content also in the future. Minna Pihlström is associated with the Centre for Relationship Marketing and Service Management (CERS) at Hanken.

How Do Different Types of Investors React to New Financial Statement Information?

The study contributes to our understanding of the forces that drive the stock market by investigating how different types of investors react to new financial statement information. Using the extremely comprehensive official register of share holdings in Finland, we find that the majority of investors are more probable to sell (buy) stocks in a company after a positive (negative) earnings surprise, and show a bias towards buying after the disclosure of new financial statement information. Large investors, on the other hand, show behavior opposite to that of the majority of investors in the market. Further, foreign investors show behavior similar to that of domestic investors. We suggest investor overconfidence and asymmetric information as possible explanations for the documented behavior.

Performance of Finnish Mutual Funds: A Decomposition Approach

Mutual funds have increased in popularity among Finnish investors in recent years. In this study returns on domestic funds have been decomposed into several elements that measure different aspects of fund performance. The results indicate that fund managers in the long run tend to allocate fund capital between different stock categories in a profitable way. When it comes to the short term timing of their allocation decisions they are however unable to further improve overall performance. The evidence also suggests that managers possess the ability to pick above average performing stocks within the individual stock categories. During the investigated period most funds returned more than a broad benchmark index even after fees and indirect costs were taken into account.

The Pricing of American Put Options on Stock with Dividends

Pricing American put options on dividend-paying stocks has largely been ignored in the option pricing literature because the problem is mathematically complex and valuation usually resorts to computationally expensive and impractical pricing applications. This paper computed a simulation study, using two different approximation methods for the valuation of American put options on a stock with known discrete dividend payments. This to find out if there were pricing errors and to find out which could be the most usable method for practical users. The option pricing models used in the study was the dividend approximation by Blomeyer (1986) and the one by Barone-Adesi and Whaley (1988). The study showed that the approximation method by Blomeyer worked satisfactory for most situations, but some errors occur for longer times to the dividend payment, for smaller dividends and for in-the-money options. The approximation method by Barone-Adesi and Whaley worked well for in-the-money options and at-the-money options, but had serious pricing errors for out-of-the-money options. The conclusion of the study is that a combination of the both methods might be preferable to any single model.

EU Accession and FDI inflows : The cases of the Czech Republic and Slovakia

Central and East European countries have faced a difficult process of transition since the dissolution of the Soviet bloc. Ten transition countries (Hungary, Poland, teh Czech Republic, Slovakia, Slovenia, Lithuania, Latvia, Estonia, Bulgaria and Romania have chosen to join the EU and have moulded their transition reforms to ensure the compliance of their legal and institutional framework with EU requirements. The high levels of FDI attracted by the candidate countries for EU membership had been attributed to rapid transition of the countries aiming to join the European Union and the fact that favourable evaluations by EU authorities of the progress made by the candidates had a large impact on improving investor confidence. The aim of this paper is to investigate the reform strategies of the Czech Republic and Slovakia undertaken when the countries were preparing for EU membership and the dynamics of FDI inflows into these economies. Subsequently a comparative analysis of FDI stocks in these countries is conducted. We find that both countries faced similar economic challenges in implementing structural and institutional reforms. In accordance with EU requirements the Czech Republic and Slovakia have perfected their legal and institutional framework, increased the authority of regulatory and supervisory bodies and focused on implementation of new or amended legislation. During the period of the analysis (1998 - 2007) the Czech Republic and Slovakia have attracted increasing amounts of FDI. Comparative analysis in terms of important determinants of FDI reveals further similar features: macroeconomic stability; an open and liberalised market; low labour costs compared to EU-15 and a similar breakdown of FDI inflows by investor country. Consequently, the fact that the Czech Republic received much larger volumes of net FDI inflows could be attributed to the difference in market size between the two states. This conclusion is consistent with previous empirical studies that list market size among the main determinants of FDI. However, when we look at FDI as a percentage of GDP the evidence is more mixed. In 2004 - 2007, Slovakia has surpassed the Czech Republic twice. Whether this tendency will persist remains to be seen. The analysis in this paper based on empirical data. However, the choice of the method, namely case studies and comparative analysis, means that the conclusions of this study are theoretical and remain to be further tested in quantitative models.

Optimal multispecies fishery management in the Baltic Sea: A bioeconomic analysis

The aim of the thesis is to assess the fishery of Baltic cod, herring and sprat by simulation over 50 years time period. We form a bioeconomic multispecies model for the species. We include species interactions into the model because especially cod and sprat stocks have significant effects on each other. We model the development of population dynamics, catches and profits of the fishery with current fishing mortalities, as well as with the optimal profit maximizing fishing mortalities. Thus, we see how the fishery would develop with current mortalities, and how the fishery should be developed in order to yield maximal profits. Especially cod stock has been quite low recently and by optimizing the fishing mortality it could get recovered. In addition, we assess what would happen to the fisheries of the species if more favourable environmental conditions for cod recruitment dominate in the Baltic Sea. The results may yield new information for the fisheries management. According to the results the fishery of Baltic cod, herring and sprat are not at the most profitable level. The fishing mortalities of each species should be lower in order to maximize the profits. By fishing mortality optimizing the net present value would be almost three times higher in the simulation period. The lower fishing mortality of cod would result in a cod stock recovery. If the environmental conditions in the Baltic Sea improved, cod stock would recover even without a decrease in the fishing mortality. Then the increased cod stock would restrict herring and sprat stock remarkably, and harvesting of these species would not be as profitable anymore.

CO2-fertilization and potential future terrestrial carbon uptake in India

There is huge knowledge gap in our understanding of many terrestrial carbon cycle processes. In this paper, we investigate the bounds on terrestrial carbon uptake over India that arises solely due to CO (2) -fertilization. For this purpose, we use a terrestrial carbon cycle model and consider two extreme scenarios: unlimited CO2-fertilization is allowed for the terrestrial vegetation with CO2 concentration level at 735 ppm in one case, and CO2-fertilization is capped at year 1975 levels for another simulation. Our simulations show that, under equilibrium conditions, modeled carbon stocks in natural potential vegetation increase by 17 Gt-C with unlimited fertilization for CO2 levels and climate change corresponding to the end of 21st century but they decline by 5.5 Gt-C if fertilization is limited at 1975 levels of CO2 concentration. The carbon stock changes are dominated by forests. The area covered by natural potential forests increases by about 36% in the unlimited fertilization case but decreases by 15% in the fertilization-capped case. Thus, the assumption regarding CO2-fertilization has the potential to alter the sign of terrestrial carbon uptake over India. Our model simulations also imply that the maximum potential terrestrial sequestration over India, under equilibrium conditions and best case scenario of unlimited CO2-fertilization, is only 18% of the 21st century SRES A2 scenarios emissions from India. The limited uptake potential of the natural potential vegetation suggests that reduction of CO2 emissions and afforestation programs should be top priorities.

Locating and sizing plants for bottling propane in south India

Shri Shakti LPG Ltd. (SSLPG) imports and markets propane (referred to as liquefied petroleum gas (LPG) in India) in south India. It sells LPG in packed (cylinder) form to domestic customers and commercial establishments through a network of dealers. Dealers replenish their stocks of filled cylinders from bottling plants, which in turn receive LPG in bulk from the cheaper of SSLPG's two import-and-storage facilities that are located on the Indian coast. We implemented integer programming to help SSLPG decide on the locations and long-run sizes of its bottling plants. We estimate that our recommended configuration of bottling plants is about $1 million cheaper annually than the one that SSLPG had initially planned.

Hydrogen generation fromammonia borane using nanocatalysts

The rapidly depleting petroleum feed stocks and increasing green house gas emissions around the world has necessitated a search for alternative renewable energy sources. Hydrogen with molecular weight of 2.016 g/mol and high chemical energy per mass equal to 142 MJ/kg has clearly emerged as an alternative to hydrocarbon fuels. Means for safe and cost effective storage are needed for widespread usage of hydrogen as a fuel.Chemical storage is the one of the safer ways to store hydrogen compared to compressed and liquefied hydrogen. It involves storing hydrogen in chemical bonds in molecules and materials where an on-board reaction is used to release hydrogen. Ammonia–borane, (AB,H3N·BH3) with a potential capacity of 19.6 wt% is considered a very promising solid state hydrogen storage material. It is thermally stable at ambient temperatures. There are two major routes for the generation of H2 from AB: catalytic hydrolysis/alcoholysis and catalytic thermal decomposition. There has been a flurry of research activity on the generation of H2 from AB recently. The present review deals with an overview of our efforts in developing cost-effective nanocatalysts for hydrogen generation from ammonia borane in protic solvents.