Higher Bid-ask Spreads Research Articles

Product market competition and the cost of equity capital

This paper provides empirical evidence that firms in more competitive industries have lower cost of equity capital than those in concentrated industries. The association between product market competition and the cost of equity capital is more pronounced with lower analyst coverage, lower forecast accuracy, higher forecast dispersion, and higher bid-ask spread. Using import tariff rate reductions as a quasi-natural experiment, we find that tariff reductions intensify domestic product market competition, which in turn reduces firms’ cost of equity capital. When the tariff rate reduction is larger, the more intensified competition reduces the cost of equity capital to a greater extent. Tariff rate reductions also influence firms’ financing policy, cash flow from operations, and growth rate.

Portfolio management using realized covariances: Evidence from Brazil

Abstract It is often argued that intraday returns can be used to construct covariance estimates that are more accurate than those based on daily returns. However, it is still unclear whether high frequency data provide more precise covariance estimates in markets more contaminated from microstructure noise such as higher bid-ask spreads and lower liquidity. We address this question by investigating the benefits of using high frequency data in the Brazilian equities market to construct optimal minimum variance portfolios. We implement alternative realized covariance estimators based on intraday returns sampled at alternative frequencies and obtain their dynamic versions using a multivariate GARCH framework. Our evidence based on a high-dimensional data set suggests that realized covariance estimators performed significantly better from an economic point of view in comparison to standard estimators based on low-frequency (close-to-close) data as they delivered less risky portfolios.

Price Discovery within Foreign Exchange Markets and the Severity of Information Risk

Using incidences of negative bid-ask spreads as evidence of information events, I find the same population of dealers manages information risk differentially, depending on the probability of informed trading within foreign exchange markets. In markets with a positive probability of negative bid-ask spreads, dealers are willing to trade-off a longer duration to information revelation for higher bid-ask spreads and predictability in bid-ask spreads. In markets with a zero probability of negative bid-ask spreads, dealers arrive at information revelation faster but at the expense of relatively lower bid-ask spreads and significantly higher volatility in bid-ask spreads. These findings provide evidence that conditional on the information structure within foreign exchange markets, dealers can generate information either by attracting informed investors or discretionary liquidity traders into foreign exchange markets.

Uncertainty and liquidity in corporate bond market

ABSTRACTWe examine the uncertainty–liquidity connection in the corporate bond market. Using monthly corporate bond data from 2005 to 2010, we construct proxies for parameter uncertainty by using firm-level parameters generated from a structural model of corporate debt. We find that uncertainty about firm parameters decreases trading volume but increases bid-ask spreads and price bouncing in the cross-section and across time. In addition, the panel VAR results show that parameter uncertainty has negative forecasting power for future bond liquidity, with greater uncertainty in the current month leading to lower trading volume, higher bid-ask spreads and higher price fluctuations on subsequent months. We conclude that parameter uncertainty is one of the underlying factors giving rise to the high level of illiquidity in the corporate bond market.

Local Twitter Activity and Stock Returns

In this study, we use geographic proximity as a measure of private information and examine the informational role of social media in stock markets. Using a large sample of individual messages (tweets) collected from Twitter during the period July 2011–March 2012, we find that local Twitter users are more likely to tweet about firms with high information asymmetry, and their Twitter activity in turn increases the trading volume of local stocks. More importantly, we find that the negative tone of local tweets predicts future stock returns and subsequent earnings announcement returns, while nonlocal tweets present no such predictability. These results suggest that local social media activity reflects new information, contributing to price discovery. We also find that the negative tone of local tweets is associated with higher bid-ask spreads and lower market depths. This finding suggests that social media – in contrast to traditional news media, which reduce firms’ information asymmetry – serve to share information with an audience in their networks and therefore increase information asymmetry among investors. Overall, our findings suggest that local social media contain value-relevant information and affect firms’ information environments.

From insurance risk to credit portfolio management: a new approach to pricing CDOs

We present a new approach for pricing collateralized debt obligations (CDOs) which takes into account the issue of the market incompleteness. In particular, we develop a suitable extension of the actuarial framework proposed by Bayraktar et al. [Valuation of mortality risk via the instantaneous Sharpe ratio: Applications to life annuities. J. Econ. Dyn. Control, 2009, 33, 676–691], Milevsky et al. [Financial valuation of mortality risk via the instantaneous Sharpe-ratio: Applications to pricing pure endowments. Working Paper, 2007. Available at: http://arxiv.org/abs/0705.1302], Young [Pricing life insurance under stochastic mortality via the instantaneous Sharpe ratio: Theorems and proofs. Technical Report, 2007. Available at: http://arxiv.org/abs/0705.1297] and Young [Pricing life insurance under stochastic mortality via the instantaneous Sharpe ratio. Insurance: Math. Econ., 2008, 42, 691–703], which is based on the so-called instantaneous Sharpe ratio. Such a procedure allows us to incorporate the attitude of investors towards risk in a direct and rational way and, in addition, is also suitable for dealing with the often illiquid CDO market. Numerical experiments are presented which reveal that the market incompleteness can have a strong effect on the pricing of CDOs, and allows us to explain the high bid-ask spreads that are frequently observed in the markets.

Debt Covenant Violations and Auditor Monitoring

We present new evidence on debt covenant violation (DCV) consequences that have not previously been examined in the literature. In particular, we show that a DCV triggers significant information asymmetry and uncertainty on the part of shareholders and auditors as reflected in higher bid-ask spreads, return volatility, and audit fees. Further, these consequences occur even when lender-imposed costs are relatively lower, consistent with the act of default itself triggering shareholder and auditor uncertainty. The results highlight costs to the firm of having bright-line rules in contracts, and add to an understanding of the consequences of DCVs.

Are SPDR Options Good for the Underlying Stocks?

Theories are inconclusive about the various impacts of the introduction of basket securities on the underlying stocks. We explore those effects for the first time around the launch of options on exchange traded funds (ETF), employing the listing of the options on the S&P 500 Depository Receipts (SPDRs) in January 2005. With known factors controlled respectively, we find that the introduction of the SPDRs options leads to lower trading volume, higher bid-ask spread, higher systematic and total risks, and lower prices for the underlying stocks, consistent with the theory that the advent of basket derivatives alters the mix of various types of portfolio traders in the related markets when they are fully integrated.

Investment Analysis of Leveraged ETFs

Due to the lower management costs and higher liquidity versus traditional mutual funds, the ETFs category has recently expanded at a faster pace than anytime before. The transparency in publicly traded ETFs gives investors access to diversified portfolios that were only available to large institutions before. In this paper, we study the ETFs’ features, benefits and disadvantages from the asset management perspective with an emphasis on the structure and risk analysis of the leveraged ETFs. Our research indicates that ETFs, though attractive in many aspects, should be managed with caution. The leveraged and inverse ETFs can result in huge negative returns due to value decay effects and high bid-ask trading spreads.

Buy-Side Analystss Participation on Public Earnings Conference Calls

Using a sample of 28,000 quarterly earnings conference call transcripts from 2008 to 2013, we examine the frequency and nature of buy-side analysts’ participation in the Q&A session of corporate earnings conference calls. We find that buy-side analysts appear on approximately 15% of all conference calls, with analysts employed by hedge funds (mutual funds) representing 46% (22%) of buy-side analyst appearances. Buy-side analysts are more likely to appear on conference calls of firms followed by fewer sell-side analysts, with higher bid-ask spreads, and not in the S&P 1500, suggesting that buy-side analysts are more likely to ask questions on conference calls when uncertainty about the firm is high. Management gives buy-side analysts priority by allowing them to ask the first question on a disproportionate number of calls. We also examine the length and tone of analysts’ interactions with management, and find that relative to sell-side analysts, buy-side analysts’ interactions are shorter and their exchanges with management exhibit less favorable tone. Finally, we document that changes in bid-ask spreads following conference calls are positively associated with buy-side participation on the call and that institutional holdings increase (decrease) when buy-side tone is relatively favorable (unfavorable). Our findings add to a growing literature on buy-side analysts by documenting their use of quarterly earnings conference calls.

Rock around the clock: An agent-based model of low- and high-frequency trading

We build an agent-based model to study how the interplay between low- and high-frequency trading affects asset price dynamics. Our main goal is to investigate whether high-frequency trading exacerbates market volatility and generates flash crashes. In the model, low-frequency agents adopt trading rules based on chronological time and can switch between fundamentalist and chartist strategies. On the contrary, high-frequency traders activation is event-driven and depends on price fluctuations. High-frequency traders use directional strategies to exploit market information produced by low-frequency traders. Monte-Carlo simulations reveal that the model replicates the main stylized facts of financial markets. Furthermore, we find that the presence of high-frequency trading increases market volatility and plays a fundamental role in the generation of flash crashes. The emergence of flash crashes is explained by two salient characteristics of high-frequency traders, i.e. their ability to i) generate high bid-ask spreads and ii) synchronize on the sell side of the limit order book. Finally, we find that higher rates of order cancellation by high-frequency traders increase the incidence of flash crashes but reduce their duration.

On the relation between the fair value option and bid-ask spreads: descriptive evidence on the recognition of credit risk changes under IFRS

This paper investigates the relationship between the use of the fair value option for liabilities (FVO) under IAS 39 and information asymmetry across investors as reflected in bid-ask spreads. Using a sample of European banks for 2006–2010, we find descriptive evidence that banks using FVO exhibit lower bid-ask spreads, relative to non-adopters. We also document that lower bid-ask spreads are still present when the control group of non-adopters is held constant while the treatment group is reduced to adopters that recognise fair value changes attributable to own credit risk changes. Moreover, the comparison of adopters with own credit risk fair value changes to other adopters shows that the recognition of these fair values is not associated with higher bid-ask spreads. Stressing the limitations of our research and highlighting the existence of alternative plausible explanations, our findings appear not to support claims that recognising fair value changes attributable to changes in the own credit risk is detrimental to the transparency of financial statements.

Information Efficiency and Firm-Specific Return Variation

Reasoning that private firm-specific information causes firm-specific return variation that drives down market-model R2s, [Morck et al., 2000, The Information Content of Stock Markets: Why do Emerging Markets have Synchronous Stock Price Movements? Journal of Financial Economics, 58, 215–260] begin a large body of research which interprets R2 as an inverse measure of price informativeness. Low-R2s or "synchronicity," as it is called in this literature, signal that prices more efficiently incorporate private firm-specific information, and high R2s indicate less. For this to be true, we would expect that low-R2 stocks have characteristics that facilitate private informed trade, i.e., lower information costs and fewer impediments to arbitrage. However, in this paper we document the opposite: Low-R2 stocks are small, young, and followed by few analysts, and have high bid-ask spreads, high price impact, greater short-sale constraints and are infrequently traded. In fact, microstructure measures suggest that private-information events are less likely for low-R2 stocks than high, and that differences in R2 are driven as much by firm-specific volatility on days without private news as by firm-specific volatility on days with private news. These results call into question prior research using R2 to measure the information content of stock prices.

Informed Options Trading Prior to M&A Announcements: Insider Trading?

We investigate informed trading activity in equity options prior to the announcement of corporate mergers and acquisitions (M&A), focusing on the target rms. We nd that the probability of informed trading in options during the period just prior to the deal announcement date is much higher than one would expect prior to any randomly chosen date. This is demonstrated by pervasive, unusual option trading volume, implied volatility and liquidity attributes. We document highly positive abnormal trading volumes, excess implied volatility, and higher bid-ask spreads, prior to M&A announcements, with stronger eects for OTM call options on the target company. The probability of option volume on a random day exceeding that of our strongly unusual trading (SUT) sample is trivial - about three in a trillion. These eects are accentuated in the sub-sample of announcements of cash oers for large target rms, particularly in a narrow window before the announcement date. We further document a decrease in the slope of the term structure of implied volatility and an average rise in percentage bid-ask spreads, prior to the announcements. We provide evidence that there is also unusual activity in volatility strategies on the acquirer. We also present a summary analysis of SEC cases involving options trading ahead of M&A announcements, and show that the SEC is more likely to investigate cases where the acquirer is headquartered outside the US, the target is relatively large, and experienced substantial positive abnormal returns after the announcement.

Rock Around the Clock: An Agent-Based Model of Low- and High-Frequency Trading

We build an agent-based model to study how the interplay between low- and high-frequency trading affects asset price dynamics. Our main goal is to investigate whether high-frequency trading exacerbates market volatility and generates flash crashes. In the model, low-frequency agents adopt trading rules based on chronological time and can switch between fundamentalist and chartist strategies. On the contrary, high-frequency traders activation is event-driven and depends on price fluctuations. High-frequency traders use directional strategies to exploit market information produced by low-frequency traders. Monte-Carlo simulations reveal that the model replicates the main stylized facts of financial markets. Furthermore, we find that the presence of high-frequency trading increases market volatility and plays a fundamental role in the generation of flash crashes. The emergence of flash crashes is explained by two salient characteristics of high-frequency traders, i.e., their ability to i) generate high bid-ask spreads and ii) synchronize on the sell side of the limit order book. Finally, we find that higher rates of order cancellation by high-frequency traders increase the incidence of flash crashes but reduce their duration.

Non-Compliance in Executive Compensation Disclosure: The Brazilian Experience

We examine the determinants and consequences of firms’ choice not to comply with a new executive compensation disclosure regulation. We exploit a unique feature of Brazilian markets, where a change in the regulation of executive compensation disclosure could arguably lead to personal security-related costs for executives. This major reform in executive compensation disclosure in Brazil became effective in December 2009. While some firms complied with the change in regulation, other firms explicitly refused to comply fully with the regulation by using a court injunction. After controlling for firm specific characteristics and both social and economic inequality measures, we find that the degree of criminality in the state in which the firm is headquartered (a proxy for security-related costs) and the level of CEO compensation are important determinants of a firm’s decision not to fully disclose executive compensation information. We also show that firms which do not fully comply with the regulation face costs in the form of higher bid-ask spreads, suggesting investors were leery of the decision not to comply with the regulation. We discuss the potential implications of our results in the context of executive compensation disclosure reform.

Impact of Macroeconomic Announcements on Interest Rate Futures: High-Frequency Evidence from Australia

This paper investigates the behavior of Australian interest rate futures around the release of major scheduled macroeconomic announcements. The analysis of price volatility, returns, trading activity and bid-ask spreads finds that the adjustment to new information occurs quickly with the significant part of the reaction complete within 30-seconds. The 30-seconds immediately prior to the announcement exhibits high volatility, low levels of volume, and high bid-ask spreads. In the 30 seconds following the scheduled announcement there is strong evidence of a sharp increase in price volatility, significant positive correlation in returns, large adjusted returns and high levels of trading activity. The reaction is stronger in shorter maturity contracts. There is some evidence of price reversals occurring following this sharp adjustment. The 2007-2008 Global Financial Crisis has had a significant impact on the reaction of Australian interest rate futures to major macroeconomic announcements, with evidence of higher volatility, significantly higher returns and decreasing market activity.

Do Stock Markets Catch the Flu?

AbstractWe examine the impact of influenza on stock markets. For the United States, a higher incidence of flu is associated with decreased trading, decreased volatility, decreased returns, and higher bid-ask spreads. Consistent with the flu affecting institutional investors and market makers, the decrease in trading activity and volatility is primarily driven by the incidence of influenza in the greater New York City area. However, the effect of the flu on bid-ask spreads and returns is related to the incidence of flu nationally. International data confirm our findings of a decrease in trading activity and returns when flu incidence is high.

R2 and Idiosyncratic Risk are not Interchangeable

A growing literature investigates the association between firm-specific stock return variation (the dependent variable) and several aspects of firms’ information and governance structures. However, several papers in this literature use the variance of residual returns from a market model (sigma squared) as the measure of firm-specific return variation whereas others use return synchronicity, or R2. Although, at first blush, these two variables appear equivalent, we show that the specific dependent variable used, sigma squared or R2, can lead to contradictory inferences due to both econometric and economic considerations. Further tests suggest that, contrary to the traditional interpretation in the literature, lower R2 is associated with poorer information environments, measured as higher price delays, higher PIN scores, greater levels of illiquidity, more zero return days and higher bid-ask spreads.

Types of agency cost, corporate governance and liquidity

We study the relationship between governance and liquidity when the agency costs of entrenched management and self-serving controlling shareholders are present. Using a sample of Chinese firms, we show a positive relationship between governance and liquidity. We also find striking differences between firms faced with different types of agency conflicts. Specifically, governance measures such as management compensation, controlling shareholder monitoring and board independence are more effective in lowering the bid-ask spread for state-owned enterprises prone to management entrenchment. In contrast, multiple-layer corporate structures and a higher degree of separation between control and cash flow rights are associated with higher bid-ask spreads in non-state firms characterized by self-serving controlling shareholders. Our study highlights how governance might have different liquidity effects between firms faced with different types of agency conflicts.