Research project Corporate information, trading, and equity market liquidity
The efficient markets hypothesis (EMH) states that equity market prices reflect all relevant information and that it is impossible to consistently outperform the market by using any information that is currently known to investors.
The EMH comes in three forms. In the weak form prices reflect all past prices, in the semi-strong form prices reflect all publicly available information, and in the strong form prices fully reflect all relevant information, including private and inside information.
Corporate information relates to the semi-strong and the strong form of EMH. Firms disclose corporate information through, e.g., quarterly announcements and other news releases. When the news become public, they are incorporated into stock prices either by market makers updating their outstanding quotes, or by investors trading on the information. Private or inside information must be traded on to be incorporated into prices. Uninformed investors, like retail traders, rely on efficient markets to get fair prices when they trade.
When market makers face the risk of trading with informed investors they quote wide bid-ask spreads and put little volume on display for trading. Hence, asymmetric information harms liquidity. We investigate how firms’ information and informed investors’ trading affect equity market liquidity, and how to properly measure these effects.
Project description
We formulate the following interrelated research questions.
1) How does corporate information affect stock market liquidity?
Stock market liquidity is important for corporate outcomes, such as firm performance, cost of capital, corporate investment, and payout policies. Also, corporate information, such as, R&D expenditure, product market power, M&A, CSR expenditure, analyst coverage, and corporate governance, affect stock market liquidity. One type of information that we know little about is firms’ carbon emissions. Carbon emissions are the largest contributor to global warming and a by-product of most economic activity. However, attention to carbon emissions has only recently become salient since, historically, carbon was emitted without cost to emitters. Faced with the evidence of rising temperatures, and policies and efforts to curb carbon emissions globally, we address whether and how corporate carbon emissions, as a new type of corporate information, affect stock market liquidity.
2) How does informed trading affect liquidity?
Informed trading is an important ingredient of financial markets. For example, informed investors help keep security prices close to fundamental values and thus are crucial for market efficiency. Informed trading also can affect asset prices by changing a firm's information structure or by changing liquidity. However, informed trading is hard to identify empirically because investors' information sets are not directly observable and because informed investors usually hide by splitting their trading over time and across different venues. We investigate trading by corporate insiders, with the focus on where they trade, and how their trading affects equity market liquidity.
3) How should we measure informed trading?
Modern equity markets are heavily fragmented, with less than half of the volume trading at traditional exchanges. Alternative venue types, sometimes called “off-exchange”, include dark pools, periodic auctions, single-dealer platforms, and over-the-counter markets. Regulators worry about the social cost of such a fragmented market structure. In the US, the Securities and Exchange Commission is mostly concerned about misuse of private customer information in peripheral markets, commonly referred to as alternative trading systems. Regulators in the EU worry about “unduly harmed price formation” if too much volume is executed off-exchange. To determine if the concerns have merit, we develop measures of the informativeness of price quotes, on-exchange trades, and off-exchange trades.
4) Do retail investors suffer from high trading costs due to asymmetric information?
Retail trading in US and European equities markets has increased significantly over the last few years because of the Covid-19 crisis and the emergence of low/zero commission brokers, which has made trading more accessible and affordable. The market structures in the US and Europe are different with respect to retail trading. Unlike in the US, where retail orders are mainly executed by wholesale market makers off-exchange, there is no dominant retail trading mechanism in Europe. Instead, retail orders can be executed using a range of mechanisms. Brokers can send retail orders to mechanisms that offer trading to all trader types and venues exclusively designed for retail trading. These trading mechanisms differ with respect to price competition and order flow segmentation.
Regulators have long debated how to protect traders and facilitate best execution. Trade execution quality is the core of market integrity and can significantly affect traders’ profit and loss. The significant increase in retail trading has highlighted the importance of an optimal retail trading mechanism facilitating best execution for retail traders. We examine retail execution quality on various European trading mechanisms to suggest the optimal one for retail traders.
Project members
Members
Fatemeh Aramian
Guest researcher
Björn Hagströmer
Professor
Alexander Hübbert
PhD student
Lars Nordén
Professor
Caihong Xu
Assistant Professor
