Common Factors in Prices, Order Flows and Liquidity

How important are cross-stock common factors in the price discovery/liquidity provision process in equity markets? We investigate two aspects of this question for the thirty Dow stocks. First, using principal components and canonical correlation analyses we find that both returns and order flows are characterized by common factors. Commonality in the order flows explains roughly half of the commonality in returns. Second, we examine variation and common covariation in various liquidity proxies and market depth (trade impact) coefficients. Liquidity proxies such as the bid-ask spread and bid-ask quote sizes exhibit time variation which helps explain time variation in trade impacts. The common factors in these liquidity proxies are relatively small, however

Episodic liquidity crises: cooperative and predatory trading,”

ABSTRACT We describe how episodic illiquidity arises from a breakdown in cooperation between market participants. We first solve a one-period trading game in continuous-time, using an asset pricing equation that accounts for the price impact of trading. Then, in a multi-period framework, we describe an equilibrium in which traders cooperate most of the time through repeated interaction and provide 'apparent liquidity' to each other. Cooperation breaks down when the stakes are high, leading to predatory trading and episodic illiquidity. Equilibrium strategies involving cooperation across markets lead to less frequent episodic illiquidity, but cause contagion when cooperation breaks down. * Bruce Ian Carlin, Miguel Sousa Lobo, and S. Viswanathan are from the Fuqua School of Business at Duke University. The authors would like to than

Equilibrium Block Trading and Asymmetric Information.

This paper investigates the existence of equilibria with information-based black trading in a multiperiod market when no investor is constrained to block trade. Attention is restricted to equilibria in which a strategic uninformed institution (i.e., one which is forced to rebalance its portfolio, but is free to choose an optimal rebalancing strategy) is willing to trade a block rather than "break up" the block into a series of smaller trades. Examples of such equilibria are found and analyzed. Copyright 1990 by American Finance Association.

Derivative Security Induced Price Manipulation

This paper investigates the potential contribution of cash market price manipulation to an option's value. When the underlying's transaction price follows an exogeneous fundamental process plus a price impact component influenced by trade, both sides of an option position may try to move the underlying cash price. Optimal cash trading strategies consist of a manipulation component and a liquidity provision for the other traders in the market. When the price impact is transitory, the optimal cash strategy may involve ``pre-liquidation'' of manipulative cash trades to reduce trading costs. We find that cash market manipulation can represent a significant portion of an option's value. The price impact of manipulation can be non-monotonic and the optimal cash trading strategy can be discontinuous in the number of longs and shorts.

Using Price Information as an Instrument of Market Discipline in Regulating Bank Risk

Presented at the Symposium on the Risk of Financial institutions, at Simon Fraser University on April 30, 2010.An important trend in bank regulation is greater reliance on market discipline. In particular, information impounded in securities prices is increasingly used to complement supervisory activities of regulators with limited resources. The goal of this paper is to analyze the theoretical foundations of market-based bank regulation. We nd that price information only improves the e ciency of the regulator's monitoring function if the banks' risk-shifting incentives are not too large. Further, if the regulator cannot commit to an ex ante suboptimal auditing policy, market-based bank regulation can lead to more risk taking in equilibrium, increasing the expected payments by the deposit insurance agency. Finally, we show that the regulatory use of market information can decrease the investors' incentives to acquire costly information, thereby reducing the informativeness of stock prices.N