Adverse Selection Costs Research Articles

Farmers’ demand for weather-based crop insurance contracts: the case of maize in south africa

ABSTRACT Weather index-based crop insurance offers farmers a way to mitigate production risk without the moral hazard, adverse selection and high administrative cost problems that plague conventional loss-based crop insurance. This is especially important for developing countries that lack government subsidised crop insurance programmes and high quality yield records. In this paper, we analyse weather-based crop insurance theoretically and provide an empirical application to South African maize producers. We examine several weather indices, investigate the farmers’ demand with and without loaded premiums, and evaluate the benefits of weather index-based insurance to farmers with alternative risk preferences. Results show that the risk management efficiency of a contract has direct bearing on how well the index describes the production variability, especially a combination of two weather variables tend to describe production risk better than any single variable.

Public information arrival: Price discovery and liquidity in electronic limit order markets

How information is translated into market prices is still an open question. This paper studies the impact of newswire messages on intraday price discovery, liquidity, and trading intensity in an electronic limit order market. We take an objective ex ante measure of the tone of a message to study the impacts of positive, negative, and neutral messages on price discovery and trading activity. As expected, we find higher adverse selection costs around the arrival of newswire messages. Negative messages are associated with higher adverse selection costs than positive or neutral messages. Liquidity increases around positive and neutral messages and decreases around negative messages. Available order book depth as well as the trading intensity increases around all news. Our results suggest that market participants possess different information gathering and processing capabilities and that negative news messages are particularly informative and induce stronger market reactions.

Information Asymmetry and Financing Decisions Around the World

We study the influence of a major reform in financial reporting regulation on financing and capital structure decisions. Across a battery of tests, we document an increase in the issuance of external financing around the new regulation. Further, firms make different leverage decisions around the new regulation depending on their ex-ante debt capacity, and use their access to external financing to rebalance their capital structure. Our results are accentuated across firms facing higher adverse selection costs and in countries with stronger institutions. Our findings highlight the importance of financial reporting regulation in explaining financing as well as capital structure policies and provide insights into which firms are more likely to benefit from it.

Signaling with Convertible Debt in High-Risk Industries

This paper analyzes how convertible debt is used in a high-risk, emerging industry setting. We argue that there is a lifecycle component to the design and market impact of convertible debt securities. Contrary to prior cross-industry research findings, we show that convertible debt in the renewable energy industry tends to have a debt-like structure, and its issue is associated with strongly nega¬tive announce¬ment returns. We further show that convertible issuers face high adverse selection costs, which they attempt to mitigate by sending signals about firm quality. However, these signals tend to fail because the market anticipates this behavior, and perceives convertible issuers as being priced out of the equity markets. Firm and industry characteristics support this view, because financial distress indicators suggest the use of more equity-like financing instruments.

The 2007–2009 financial crisis and bank opaqueness

Abstract Doubts about the accuracy with which outside investors can assess a banking firm’s value motivate many government interventions in the banking market. Although the available empirical evidence is somewhat mixed, the recent financial crisis has reinforced a common assessment that banks are unusually opaque. This paper examines bank equity’s trading characteristics during “normal” periods and two “crisis” periods between 1993 and 2009. We find only limited (mixed) evidence that banks are unusually opaque during normal periods. However, consistent with theory, crises raise the adverse selection costs of trading bank shares relative to those of nonbank control firms. A bank’s balance sheet composition significantly affects its equity opacity, but we cannot detect specific balance sheet categories that have robust effects.

On the Design of Sell-Side Limit and Market Order Tactics

This article provides a novel framework to evaluate limit order tactics that highlights expected fill price, adverse price selection cost, and opportunity cost. We formulate the problem of optimal execution of market orders with nonlinear market impact, power law decay kernel, and stochastic and deterministic liquidity constraints. We demonstrate how these tactics can be incorporated in the uncertainty bands framework. <b>TOPICS:</b>Statistical methods, risk management

Latency, liquidity and price discovery

The speed of trading is an important factor in modern security markets, although relatively little is known about the effect of speed on liquidity and price discovery, two important aspects of market quality. On April 23, 2007, Deutsche Boerse made an important upgrade to their trading system. With the 8.0 release of Xetra, system latency was reduced from 50ms to 10ms. Subsequently, both quoted and effective spreads decreased, which are mainly concentrated in small- and medium-sized stocks. This increase in liquidity is due to dramatically lower adverse selection costs that were only partially translated into higher liquidity. We interpret this as a decrease in the competition between liquidity suppliers who are able to increase their revenues by more than 90 million euros. The contribution of quotes to price discovery doubles to 90% post upgrade, indicating that prices are more efficient.

The Role of Microinsurance as a Safety Net Against Environmental Risks in Bangladesh

The Intergovernmental Panel on Climate Change (IPCC) identifies Bangladesh as one of the countries that will be hardest hit by the anticipated effects of climate change. The poorest people are the most vulnerable, as they do not have sufficient means to cope with environmental risks. In the absence of effective safety nets, poor people become trapped in chronic poverty due to the recurrent damage caused by natural disasters. Recently, there has been growing optimism among policy makers and practitioners about the role of microinsurance as a safety net against weather risks for the poorest and most vulnerable people of Bangladesh. This article sheds light on this issue by synthesizing the findings of half a decade of research on the prospects of weather microinsurance in Bangladesh. Three key conclusions are drawn from the synthesis. First, the market for a standard, stand-alone weather microinsurance in Bangladesh is characterized by low demand, poor governance, and lack of prospects for commercial viability. Second, although the index-based flood insurance model has theoretical appeal (i.e., no moral hazard or adverse selection and low transaction cost), high economic cost might be associated with its highly complex practical implementation. Finally, the current (un)regulatory arrangement of microinsurance supply in Bangladesh, which does not guarantee accountability and protect clients’ rights, is likely to increase rather than decrease poor people’s vulnerability. The study makes two key recommendations: (1) exploring options for nontraditional insurance models (e.g., group-based and ex-post premium-based models), and (2) considering regulatory reforms to ensure good governance and to foster market efficiency through low-cost delivery and product innovation.

Is Best Really Better? Internalization of Orders in an Open Limit Order Book

We study the market quality of the Xetra BEST system operated by Deutsche Borse AG, an internalization system designed as part of an open limit order book, which guarantees a price improvement over the inside spread in the Xetra order book. We develop a structural model of this dual market environment and show that adverse selection costs of internalized trades are significantly lower than those of regular order book trades while realized spreads are significantly larger. The cost savings of the internalizer are larger than the mandatory price improvement, suggesting that internalization can be profitable for both customer and internalizer.

Governance, Liquidity and Adverse Selection in Asset Pricing

Gompers, Ishii and Metrick (2003) and other researchers found significant evidence for governance related premia explaining stock returns. We hypothesize bad governance leads to information asymmetry which in turn leads to illiquidity of stocks. Thus governance characteristics are just a proxy for information asymmetry that is better captured by the liquidity and adverse selection component of a company’s shares. Companies governed by managers who are not embracing shareholder rights will attract fewer investors and, hence, have less liquid stocks and more adverse selection costs. In a series of standard asset pricing tests we examine the joint effect of governance and liquidity on the asset pricing paradigm and we find that liquidity and information asymmetry premia dominate the governance effect. Hence, we show that governance characteristics are priced. But this holds only as long as liquidity and adverse selection factors are not taken into account. Our results are robust to different proxies for liquidity and governance.

Risk Measures and Fine Tuning of High Frequency Trading Strategies

We propose risk metrics to assess the performance of High Frequency (HF) trading strategies that seek to maximize profits from making the realized spread where the holding period is extremely short (fractions of a second, seconds or at most minutes). The HF trader maximizes expected terminal wealth and is constrained by both capital and the amount of inventory that she can hold at any time. The risk metrics enable the HF trader to fine tune her strategies by trading off different metrics of inventory risk, which also proxy for capital risk, against expected profits. The dynamics of the midprice of the asset are driven by information flows which are impounded in the midprice by market participants who update their quotes in the limit order book. Furthermore, the midprice also exhibits stochastic jumps as a consequence of the arrival of market orders that have an impact on prices which can give rise to market momentum (expected prices to trend up or down). The HF trader's optimal strategy incorporates a buffer to cover adverse selection costs and manages inventories to maximize the expected gains from market momentum.

Liquidity Benefits from IPO Underpricing: Ownership Dispersion or Information Effect

The positive relation between initial underpricing and liquidity in the secondary market several months after the initial public offering has been previously attributed to ownership dispersion induced by underpricing. We show that public information production can be another channel by which underpricing improves liquidity. Using a sample of IPOs undertaken on Euronext, we show that the analyst coverage engendered by initial underpricing reduces information asymmetry costs and illiquidity in the secondary market. Regarding information asymmetry, the impact is statistically more significant on measures based on adverse selection costs than on measures based on the proportion of informed traders in the market.

Does Information Sharing Reduce the Role of Collateral as a Screening Device?

Information sharing and collateral reduce adverse selection costs, but are costly for lenders. When a bank learns more about the types of its rival's borrowers through information sharing (e.g., credit bureaus), it might seem that this information should substitute the role of collateral in screening their types. We instead show that information sharing may increase, rather than decrease, the role of collateral, which can be required in loans to high-risk borrowers in cases when it is not in the absence of information sharing. We extend to show that ex ante screening can substitute both collateral and information sharing.

Institutional investors' holdings surrounding equity rights offerings

We examine shareholding surrounding Swedish rights offerings using detailed information on the ownership in firms. We analyze shareholding levels and their changes for domestic and foreign institutional investors. As institutional holdings change, domestic institutions increase their holdings more than foreign institutions. Our examination of low and high buying activities by institutional investors surrounding rights offerings shows no stock picking ability, thus not supporting the “smart-money hypothesis” (Gibson et al., 2004). We also find that investor domicile influences firm value following the offering. Overall, foreign investors exhibit a strong and opposite directional reaction to adverse selection costs than domestic investors.

Capital Structure, Risk and Asymmetric Information

This paper argues that firms may not issue debt in order to avoid the adverse selection cost of debt. Theory suggests that since debt is a concave claim, it may be mispriced when outside investors are uninformed about firms' risk. The empirical literature has however paid little attention to the caveat that the "lemons" problem of external financing first identified by Myers (1984) only leads to debt issuance, i.e., a pecking order, if debt is risk free or, if it is risky, that it is not mispriced. This paper examines whether and for what firms the adverse selection cost of debt is more than a theoretical possibility and how this cost relates to other costs of debt such as bankruptcy. In the absence of any direct measure of something that is unknown to investors and thus cannot be in the econometrician's information set, we present extensive strong and robust evidence in a large unbalanced panel of publicly traded US firms from 1971 to 2001 that firms avoid issuing debt when the outside market is likely to know little about their risk.

Section 404 of the Sarbanes-Oxley act and its capital market effects

Starting with November 15, 2004, Section 404 of the Sarbanes-Oxley Act of 2002 (SOX 404) requires all accelerated firms (with at least $75 million in public equity) to report on the effectiveness of their internal controls over financial reporting. There has been some controversy regarding the burden that it casts on companies and whether the benefits outweigh the costs of compliance. Reporting under SOX is meant to improve investor confidence concerning the stock of a specific company by adding credibility to its financial statements. An increase in the quality of financial information should determine a narrowing of the bid-ask spread. I identify the cost components of the market makers bid-ask spread for a sample of stocks surrounding the implementation of SOX 404. The expectation is that market makers react to the implementation of Section 404 as if information asymmetry has diminished. The study uses the model developed by Bollen et al.(2004) to separate the cost components of the bid-ask spread for a sample of compliant firms in the period surrounding the implementation of SOX 404. Key words: Bid-ask spread, informed trading, information asymmetry, internal controls, adverse selection cost.

Evaluating spread models with a basket security

In this article we evaluate the most widely used spread decomposition models using Exchange Traded Funds (ETFs). These funds are an example of a basket security and allow the diversification of private information causing these securities to have lower adverse selection costs than individual securities. We use this feature as a criterion for evaluating spread decomposition models. Comparisons of adverse selection costs for ETF's and control securities obtained from spread decomposition models show that only the Glosten-Harris (1988) and the Madhavan-Richardson-Roomans (1997) models provide estimates of the spread that are consistent with the diversification of private information in a basket security. Our results are robust even after controlling for the stock exchange. © 2011 Copyright Taylor and Francis Group, LLC.

Subsidizing Liquidity: The Impact of Make/Take Fees on Market Quality

Facing increased competition, over the last decade many stock exchanges changed their trading fees to maker-taker pricing, an incentive scheme that rewards liquidity suppliers and charges liquidity demanders. Using a change in trading fees on the Toronto Stock Exchange, we study whether and why the breakdown of trading fees between liquidity demanders and suppliers matters. Posted quotes adjust after the change in the fee composition, but the transaction costs for liquidity demanders remain unaffected once fees are taken into account. Yet, as posted bid-ask spreads decline, traders, in particular retail, use aggressive orders more frequently, and adverse selection costs decrease.

Institutional Analysis of Revolving Fund Loan (RFL) for the Development of Community Forest Plantations (CFP)

The purpose of this study was to formulate effective and efficient institutions of Revolving Fund Loans for Community Forest Plantation development (RFL CFP) in accordance with variation of field conditions. Benchmarking techniques were used to formulate the institution of RFL CFP. For that purpose, Independent of Direct Assistance Rural Agribusiness Development (IDA RAD) from the Ministry of Agriculture was selected as a benchmark as it was good in performance. The study was conducted in three provinces, i.e. Riau, South Kalimantan (November 2008 to April 2009) and West Java (May 2009 to February 2011). Comparative study was used to analyze the institutions based on the agency theory. The results showed that the institutional of RFL CFP have not accomodated the differences in characteristics, perceptions and capacities of the parties. As a result, the institutions have not been able to overcome the risk of moral hazard, adverse selection and high transaction costs. On the other hand, the institution of IDA RADhas a positive impact on agency relationship. High repayments by IDA RADagent and the increasing number of agents each year have proved the impact.

Non-Public Information and the Trading Activity of Hedge Funds

Informed trading reduces liquidity but speeds price discovery. I compare trading by shareholder activists with trading by the subset of hedge fund activists in lead-up periods before activists disclose adjustments in target firm ownership. Activist trading widens target bid-ask spreads and increases Amihud illiquidity (Amihud (2002)). These effects intensify as hedge funds trade physically closer to their targets. Close hedge fund trading before earnings surprises impounds the news into stock prices faster than other activists, reducing abnormal announcement return volatility by 29 percent. I conclude informed trading produces a trade-off between lower liquidity through adverse selection costs and more informative prices.