Asymmetric Information Component Research Articles

Price formation in call auctions with insider information

PurposeThis study aims to investigate – theoretically and empirically – if call auctions incorporate asymmetric information into prices.Design/methodology/approachFirst, this study introduces a new model of price formation in a call auction with insider information. In this call auction model, insider trading gives rise to an asymmetric information component of transaction costs. Next, this study estimates the model using 20 stocks from Euronext Paris and investigates if the asymmetric information component is present.FindingsThe theoretical analysis reveals that call auctions incorporate asymmetric information into prices. The empirical analysis finds strong evidence for the asymmetric information component. Testable implications provide further support for the model.Practical implicationsCall auctions have recently been proposed as an alternative to continuous limit order book markets to overcome problems associated with high-frequency trading. However, it is still an open question whether call auctions efficiently aggregate asymmetric information. The findings of this study imply that call auctions facilitate price discovery and, therefore, are a viable alternative to continuous limit order book markets.Originality/valueThere is no generally accepted measure of trading costs for call auctions. Therefore, the measure introduced in this study is of great value to anyone who wants to quantify trading costs in call auctions, understand the determinants of trading costs in call auctions or compare trading costs and their components between continuous markets and call auctions. This study also contributes to the literature devoted to estimating the probability of information-based trading.

The components of the bid‐ask spread: Evidence from the corn futures market

AbstractThis article examines whether USDA announcements and commodity index fund rolling activity have an impact on liquidity costs, measured by the bid‐ask spread. Using Huang and Stoll's (1997) model of liquidity costs, we estimate whether changes to liquidity costs are driven by its adverse selection, inventory, or order processing components. Commodity index fund roll activity reduces the asymmetric information cost component of liquidity cost due to an increased proportion of noninformation‐based trading, but the inventory cost component increases as (mostly long only) commodity index funds sell their nearby positions and buy the first deferred contract—raising liquidity providers’ risk of building a position. The sum of these two effects is that liquidity costs remain low during index fund roll periods, averaging one “tick” (0.25 cents). On USDA report release days, we find that informed traders raise the asymmetric information component of liquidity costs in the first hour after release, but the inventory cost component is reduced due to the increase in volume. Similar to index fund roll activity, liquidity costs on USDA report release days remain low, averaging one “tick”. Our findings that liquidity costs are minimally changed during USDA report releases and commodity index fund roll periods is consistent with other recent research on liquidity costs, but we show that what drives liquidity costs differs substantially depending on the circumstances surrounding daily trading.

Tick Size Reduction and the Components of the Bid-Ask Spread on the Taiwan Stock Exchange

We examined the effect of reduced tick size on spread and its various components on Taiwan Stock Exchange (TWSE). The TWSE stands for a representative order-driving call mechanism in the emerging market. The noticeable market features of the TWSE render our findings on the effect of tick-size changes useful in combination with those reported in studies on developed markets. Our evidence strongly indicated that the traded spread and the order-processing component declined after tick size was reduced, whereas the asymmetric information component exhibited less significant changes. We documented a relatively high proportion of the order-processing component of the TWSE compared with that observed in developed markets after tick size was reduced. The cross-sectional regression analysis results indicated that stocks with high binding constraints, a high price, and high trading activity generated substantial savings on the order-processing component after tick-size conversion. Our empirical results highlight the important contributions of reduced tick size on market efficiency specifically in an emerging call market setting.

Modelling time-varying asymmetric information component of transaction costs

ABSTRACTThe main purpose of this paper is to model time-varying asymmetry information costs. To do this, first, we use two classical reduced-form microstructure models defined in a Bayesian hierarchical framework. In this scenario, we consider adverse selection as a random unobserved state variable and we use the Markov chain Monte Carlo (MCMC) estimator. And second, we evaluate whether time-varying asymmetric information cost estimates reflect the existence of periodicity (intraday patterns, time-of-day effects) and mean reversion in one stock. This procedure is applied to tick-by-tick quote and trade data on 15 SIBE-listed stocks over the 126 trading days since January–June 2005, estimating the unobserved time-varying costs for different hourly intervals. The main results indicate that our model captures periodicity between trading sessions and time-varying adverse selection costs showing the U-shape intraday pattern and mean reversion.

Decomposing the Bid–ask Spread in Multi‐Dealer Markets

AbstractIn this paper, we modify the Huang and Stoll spread‐decomposing model to fit multi‐dealer markets. In a multi‐dealer market, individual dealers can rebalance their inventories either by trading with other dealers or by changing the quote price. Our modified model captures this feature. Using transaction data from the Reuters D2000‐1 system, we find that the order‐processing and inventory control components of the spread in the foreign exchange market are relatively small and dealers may tolerate the unwanted inventory to keep the spread small to attract informed orders. The asymmetric information component carries the biggest weight. We study the time pattern of the spread and its components. The spread varies significantly with the time of day, but the inventory control and asymmetric information components do not. Copyright © 2015 John Wiley & Sons, Ltd.

Are foreign IPOs really foreign? Price efficiency and information asymmetry of Chinese foreign IPOs

We investigate the informational risk and price efficiency of Chinese firms undertaking a foreign IPO on the Hong Kong stock exchange between 1996 and 2012. Specifically, using intraday tick data, we examine the spreads, asymmetric information component of the bid-ask spread, autocorrelations of intraday returns, variance ratios and return predictability of the order flow for foreign IPO firms. We contrast these measures against those of comparable IPO firms on both the Chinese stock exchanges and the Hong Kong stock exchange matched based on the year of IPO, industry and firm size. We find that while the foreign IPO firms largely operate in China, they are generally perceived as having a similar level of information asymmetry and price efficiency as Hong Kong IPO firms. In contrast, IPOs on the Chinese exchanges have much higher proportions of information asymmetry in their spreads and lower price efficiency than foreign IPO firms. Our findings are generally robust to the use of the Heckman two-stage procedure that controls for potential self-selection bias. Our results provide further evidence that it is the location of trading that is important for pricing of firms rather than the location of their business.

Target’s earnings quality and bidders’ takeover decisions

This study examines how takeover decisions are influenced by the quality of information in target firms’ earnings. We show that bidders prefer negotiated takeovers in deals involving targets with poor earnings quality. Moreover, earnings quality and takeover premiums are negatively related in negotiated takeovers, suggesting that bidders obtain valuable private information through negotiations. We also find that bidders share information risk with target shareholders by paying with more equity for targets with poor earnings quality. These findings are driven primarily by the asymmetric information component of earnings quality (as opposed to the symmetric component) and are observed mainly in inter-industry takeovers, where asymmetric information concerns are greater, rather than in intra-industry takeovers. We conclude that targets’ earnings quality affects bidders’ takeover decisions, particularly in cases of large asymmetric information between targets and bidders.

Targets' Earnings Quality and Bidders' Takeover Decisions

This study examines how takeover decisions are influenced by the quality of information in target firms’ earnings. We show that bidders prefer negotiated takeovers in deals involving targets with poor earnings quality. Moreover, earnings quality and takeover premiums are negatively related in negotiated takeovers, suggesting that bidders obtain valuable private information through negotiations. We also find that bidders share information risk with target shareholders by paying with more equity for targets with poor earnings quality. These findings are driven primarily by the asymmetric information component of earnings quality (as opposed to the symmetric component), and are observed mainly in inter-industry takeovers, where asymmetric information concerns are greater, rather than in intra-industry takeovers. We conclude that targets’ earnings quality affects bidders’ takeover decisions, particularly in cases of large asymmetric information between targets and bidders.

Why Designate Market Makers? Affirmative Obligations and Market Quality

While some financial markets increasingly rely on endogenous liquidity provision by “high frequency” traders, others also contract with “designated market makers” who commit to provide more liquidity than they would otherwise choose. We identify two reasons that such affirmative obligations can improve value. The first relies on the insight that the asymmetric information component of market-making costs comprises a transfer across traders, not a social cost to completing trades. As such, this cost dissuades efficient trading, which a restriction on spread widths encourages. Secondly, a restriction on spread widths encourages more traders to become informed, which speeds the rate at which market prices move toward true asset values. This analysis implies that designated market makers can enhance efficiency primarily when actual or perceived information asymmetries are important, not simply when liquidity is expensive or trading is sparse. As the “flash crash” of May 2010 has been attributed to the withdrawal of endogenous liquidity in response to perceived increases in information asymmetries, our analysis implies that future flash crashes can be avoided and social welfare enhanced by designating market makers.

Tick Size and Adverse Selection: Spurious Effects Arising from Serial Correlation

In this paper, we demonstrate using a simple model that reducing tick size may either reduce or increase adverse selection. Therefore, the effect of tick size on adverse selection is an important empirical question. At the same time, we demonstrate that the standard asymmetric information models used to estimate effects of informed trading rely on econometric techniques that may give spurious results. Using simulations from an equilibrium model with no asymmetric information but endogenously determined market orders, we demonstrate that standard techniques may generate a positive asymmetric information component even when the true one is zero, and that this upward bias in the adverse selection component is affected by tick size. This bias occurs in part from serial correlation of order flow that may increase under sufficiently small tick sizes due to orders being split.

Liquidity and Competition in Unregulated Markets: The New York Stock Exchange Before the SEC

Despite reputedly widespread market manipulation and insider trading, we find surprisingly high liquidity and low transactions costs for actively traded securities on the NYSE between 1890 and 1910, decades before SEC regulation. Moreover, market makers behave largely as predicted in theory: stocks with liquid markets and competitive market makers (cross-trading at the rival Consolidated Exchange) trade with substantially lower quoted bid-ask spreads and with less anti-competitive behavior (price discreteness). Effective spreads, illiquidity, and volume all improve monotonically over time. Notably, the asymmetric information component of effective spreads increases in relative and absolute terms from 1900 to 1910.

Decomposing liquidity along the limit order book

In this paper, we estimate the asymmetric information and order processing components of liquidity at extended depths along the limit order book. Using data from the INET ECN, we find that the asymmetric information component decreases as depth increases. Inactive stocks have more information asymmetry at the inside quotes, but it decreases more rapidly along the book than for active stocks. The order processing component of liquidity has fixed and variable constituents, consistent with a fixed cost per order as well as a variable portion based on the size of the order.

The liquidity effects of revisions to the S&P 500 index: an empirical analysis

We study liquidity effects following S&P 500 index revisions. Using a recent sample of S&P 500 additions, we find a sustained increase in the liquidity of the added stocks. Further, the improvement in the liquidity of added stocks is due primarily to a decrease in the direct cost of transacting and a smaller decline in the asymmetric information component. Finally, the event period cumulative abnormal returns for additions are significantly associated with the decrease in the effective spread, particularly the decline in the direct cost of transacting. In contrast, the liquidity of deleted stocks declines over the three months following deletion.

Components of execution costs: evidence of asymmetric information at the Mexican Stock Exchange

Immediate execution costs for stocks trading at the auction market of the Mexican Stock Exchange (MSE) are five times higher than those for similar NYSE stocks. The source of the trading cost differential is asymmetric information. Mexican stocks are associated with a substantially larger asymmetric information component of the spread (2.76 cents per dollar) than their matched NYSE counterparts (0.28 cents). Results indicate that differences in asymmetric information are not related to stock characteristics, number and sophistication of security analysts, listing and disclosure requirements, ownership restrictions, and voting rights.

The Changing Asymmetric Information Component of REIT Spreads: A Study of Anticipated Announcements

This study examines the risk-compensating behavior of REIT market makers. The bid-ask spread is hypothesized to compensate market makers for three costs: asymmetric information, order processing, and inventory. As the market maker's perceived likelihood of transacting with a better-informed individual increases (decreases), the percentage of the spread that is attributed to asymmetric information will increase (decrease). This study examines the asymmetric information component of the bid-ask spread immediately prior to and following REIT dividend announcements and REIT funds from operations announcements during 1995 and 1996. The asymmetric information component increases the day before and then declines subsequent to dividend announcements of small and equity REITs. Asymmetric information costs increase following funds from operations announcements.

INFORMED TRADING RISK AND BID‐ASK SPREAD CHANGES AROUND OPEN MARKET STOCK REPURCHASES IN THE NASDAQ MARKET

AbstractMicrostructure theory contends that dealers' bid‐ask spreads should vary intertemporally with changes in the asymmetric information component of the spread. Corporate theory suggests that stock repurchase announcements signal management's private information to the securities markets. An examination of dealers' spread behavior around firms' open market repurchases in the NASDAQ market reveals a decline in spreads adjusted for dealers' inventory‐holding and order‐processing costs. This decline is attributed to a reduction in informed trading risk associated with the open market repurchase announcements.