Essays in Microstructure Liquidity, Asset Pricing, and Short Selling

Abstract

This thesis consists of three standalone studies in the fields of market microstructure liquidity, asset pricing, and short selling. The first study examines whether microstructure illiquidity is priced in security returns in the presence of buyers and sellers having identical preferences and facing symmetric liquidity costs. Commencing with a Lucas (1978)-type representative investor but with differing endowments, we develop a new theoretical model of counterparty trading inclusive of frictions to show that symmetric liquidity costs, which could arise either from exogenous costs or from order-flow asymmetric information, are not priced. This is because seller costs cancel out the buyer costs correctly identified in Amihud and Mendelson's (1986a) seminal theoretical model. We test our generalization of the Lucas model utilizing NYSE (US) equity market microstructure data to show that we cannot reject our main hypothesis concerning the absence of liquidity pricing effect on stock returns. We split transaction costs into their buy (upside) and sell (downside) components to find they are priced with similar magnitudes in contemporaneous returns. Based on our NYSE sample, the balanced effect of buy and sell lambda price impact does not generate a downside lambda premium in future stock returns. We further report a positive pricing effect of the bid-ask spread on future returns on the extreme quintile of lambda asymmetry. The second study examines liquidity asymmetry under variations in short selling regimes. I show a near symmetrical adverse effect of shorting flow impediments (caused by an exchange driven short-sale ban or securities lending market-driven constraints) on the buy and sell order flow price impact and liquidity supply dynamics. Overall, I find that the liquidity cost asymmetry is lower than the previously reported outcome with the US 2008 banned stocks in an extreme liquidity crisis. The differential effect is tilted towards sell-initiated order flow impact and bid side liquidity. Utilizing tick-by-tick microstructure data (including depth data) in the Hong Kong market, I conduct ordinary least squares (OLS) and regression discontinuity design (RDD) tests on the Hong Kong market to corroborate my findings. In contrast to Diamond and Verrecchia (1987), my study: a) argues for the importance of informed short sellers (as liquidity suppliers) on the bid and ask side of the market, and b) highlights the juxtaposition between the imperfect competition channel and increased adverse selection due to endogenous information acquisition under an informed short-selling ban. I further report a lower differential effect in buy versus sell under stronger mean reversion properties, a profitable setting for contrarian liquidity provisioning strategies. In the third study, I utilize a novel data panel of institutional short-sell transactions (with identification flags for hedgers and non-hedgers), equity covered put warrant data, and securities lending data based on the Taiwan market to show that put warrant derivatives hedge rebalancing raises borrowing costs (loan fees). The short-sell hedging demand is inelastic to fees. The positive fee effect with increased hedging becomes significantly strong for expensive-to-borrow stocks that have liquid at-the-the-money warrants. Traders who engage in such hedging have a solid motivation to manage downside risk due to price fluctuations and active hedge rebalancing requirements because of the sensitive delta. This risk management requirement is reflected in fees charged by lenders. My analysis provides insights into whether regulators and investors should be wary of increased bearish trading strategies in the derivatives market, which could inflate short-selling costs in the lending market. I further find that warrant hedgers’ demand is sensitive to fees before negative earnings announcements, i.e., hedgers’ short-selling demand declines with higher loan fees. This effect reflects the fact that such hedgers short when they expect higher selling pressure, i.e., they sell low. In contrast, I find that the short-selling demand of traders who are not hedgers is positively associated with costs before the negative earnings information because they feel an urgency to generate profit with overvalued stocks; in other words, they sell high when in receipt of private bad news