Issues in pricing, liquidity, information efficiency, asymmetric information and trading sysyems

Abstract

Market microstructure is a relatively new area in finance which emerged as a result of inconsistency between actual and expected prices due to a variety of frictions (mainly trading frictions and asymmetric information) and the realisation that the trading process through which investors' demand is ultimately translated into orders and volumes is of greater importance in price formation than it was originally thought. Despite increased research in the area of liquidity, asset pricing, asymmetric information and trading systems, all subfields in the area of market microstructure, there are a number of questions that remain unanswered such as the effect of different trading systems on systematic liquidity, informational efficiency or components of the spread. This thesis aims at shedding light on those questions by providing a detailed empirical investigation of the effect of trading systems on systematic liquidity, pricing, informational efficiency, volatility and bid-ask spread decomposition mainly with respect to the UK market (FTSEIOO and FTSE250) and to a less extent with respect to the Greek market. Those two markets are at different levels of development/sophistication and are negatively correlated.The aims of this thesis are outlined in chapter one with chapter two providing a detailed review of the theoretical literature relevant to this study. Chapter three is the first empirical chapter and tests for the presence of a common underlying liquidity factor (systematic liquidity) and its effect on pricing for FTSE100 and FTSE250 stocks under different trading regimes. Results show the presence of commonality for FTSE100 and FTSE250 stocks although commonality is weaker for FTSE250 stocks and its role on pricing is reduced. Chapter four investigates the same issues with respect to the Greek market and we find that commonality appears to be stronger in some periods while it is reduced to zero for other periods. Chapter five focuses on the effect that changes in the trading systems can have on informational efficiency and volatility primarily with respect to FTSE100 and FTSE250. Different methodologies and data are employed for this purpose and produce similar results. We find that order driven markets are more responsive to incoming information when compared to quote driven markets. Volatility has a greater impact on the spread when the market is quote driven. We also examined if automated trading increased informational efficiency with respect to the Greek market. The results obtained indicated that the effect of automation was positive. Finally the last chapter focused on the effect of different trading systems on the components of the spread and their determinants. Our main finding is that the asymmetric component of the spread is higher under a quote driven market. Also stock volatility appears to affect the asymmetric component to a greater extent when the market is quote driven. We believe that the main justification for those findings is affirmative quotation.