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Market Microstructure. (Bureau News).

The NBER's Working Group on Market Microstructure met in Cambridge on November 30. Organizers Bruce Lehmann, NBER and University of California at San Diego; Andrew W Lo, NBER and MIT; Matthew Spiegel, Yale University; and Avanidhar Subrabmanyam, University of California at Los Angeles, chose these papers for discussion:

Hendrik Bessembinder, University of Utah, and Kumar Venkataraman, Southern Methodist University, "Does an Electronic Stock Exchange Need an Upstairs Market?"

Discussant: Elizabeth OddersWhite, University of Wisconsin, Madison

Tim Bollerslev, NBER and Duke University, and Hao Zhou, Federal Reserve Board, "Order Flow, Market Risk, and Daily Stock Returns"

Discussant: S. Viswanathan, Duke University

Gunter Strobi, University of Pennsylvania, "On the Optimal Allocation of New Security Listings to Specialists"

Discussant: Kathleen Hagerty, Northwestern University

Joel Hasbrouck and Gideon Saar, New York University, "Limit Orders and Volatility in a Hybrid Market: The Island ECN"

Discussant: B. Swaminathan, Cornell University

Tarun Chordia, Emory University, "Liquidity and Returns: The Impact of Inclusion into the S&P 500 Index"

Discussant: Amber Anand, Syracuse University

Bessembinder and Venkataraman investigate the costs and benefits of using an "upstairs" market, in which trades are facilitated through search and negotiation, to execute large equity transactions. The Base de Donnees de Marche (BDM) database from the Paris Bourse identifies upstairs-facilitated trades and trades in the "downstairs" (electronic limit order) market. Using data on 92,170 block transactions in a broad cross-section of firms from the Paris Bourse, the authors test several theoretical predictions about upstairs trading and investigate the effect of market structure on trading costs. They find that the upstairs market at the Paris Bourse is an important source of liquidity for large transactions. These results support the hypothesis that the role of an upstairs broker is to lower the risk of adverse selection in the upstairs market by certifying a block order as being uninformed. In addition, for the subset of stocks with less restrictive crossing rules (eligible stocks), the authors find that a v ery high proportion of the upstairs trades are executed at prices near the quotes. These results suggest that market participants closely monitor the liquidity in the downstairs markets, and the right to execute away from the quotes is used only sparingly, and for the largest orders. For the U.S. markets, these results imply that less restrictive crossing rules may not result in worse execution for the block participants.

Bollerslev and Zhou explain individual daily stock returns with a fundamental ICAPM component and an idiosyncratic liquidity component. Guided by a theoretical market microstructure model which directly links the liquidity premium to the noise trading risk, the informational trading risk, and the systematic volatility risk, they find that: 1) explicitly incorporating the idiosyncratic liquidity component almost doubles the explanatory power of the standard ICAPM; 2) the liquidity premium is almost exclusively compensating for idiosyncratic volatility risk as opposed to market wide volatility risk; and 3) the signed order flow and, to a lesser degree, the signed trades are both informative about the idiosyncratic liquidity risk, while standard raw volume-based measurements are not.

Strobl addresses the question of how securities with correlated payoffs should be optimally allocated to dealers in a specialist system. Using an adverse selection model with riskaverse traders, he compares different market-making scenarios and derives equilibrium prices in closed form. He demonstrates that specialists are always better off when their assets are highly correlated and provides condi tions under which investors will prefer such a situation as well. Intuitively, this is the case when the investors' expected endowment shocks are large, specialists are sufficientiy risk averse, and competition between specialists is weak.

Hasbrouck and Saar present an empirical analysis of trading activity on the Island ECN, an alternative trading system for U.S. equities that is organized as an electronic limit order book. They focus on a cross-sectional investigation of the relations between different forms of volatility and various Island trading measures. They find that higher volatility is associated with: a lower proportion of limit orders in the incoming order flow; a higher probability of limit order execution; shorter expected time to execution; and lower depth in the book. In addition, Island's market share for a given firm is related positively to the overall level of Nasdaq trading in the firm. The authors document substantial use of hidden limit orders (for which the submitter has opted to forgo display of the order). Finally, over one quarter of the limit orders submitted to Island are canceled (unexecuted) within two seconds or less. The extensive use of these "fleeting" orders is at odds with the view that limit order traders (like dealers) are patient providers of liquidity.

Chordia takes an event study approach to the cross-sectional relationship between returns and liquidity to obtain strong results. The event is the inclusion of a firm into the S&P 500 index. Because the inclusion decision is unpredictable, the inclusion provides a clean natural experiment. Chordia documents a statistically and economically significant increase in liquidity when a stock is included in the index. Moreover, stock returns in the three-year or the one-year period after the inclusion date are significantly lower than in the corresponding period before the inclusion date. This supports the notion that investors demand a premium for buying illiquid securities. The result is also consistent with Merton's investor base hypothesis. The price pressure hypothesis is not supported.
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Publication:NBER Reporter
Date:Dec 22, 2001
Previous Article:Corporate Finance. (Bureau News).
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