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©R. Schwartz Equity Markets: Trading and StructureSlide 1 Topic 4

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©R. Schwartz Equity Markets: Trading and StructureSlide 2 The Frictionless Environment

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©R. Schwartz Equity Markets: Trading and StructureSlide 3 A Perfect, Frictionless World No transaction costs CAPM Stocks have intrinsic values What does this mean? a No. Shares Price Infinitely elastic demand to hold shares Infinite elasticity implies infinite liquidity – what explains it?

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©R. Schwartz Equity Markets: Trading and StructureSlide 4 Stocks and Portfolios have Replicating Portfolios in a CAPM World The covariance of a stocks returns with the market portfolios returns can be replicated Cov (A,M) > Cov (B,M) > Cov (C,M) With proper weights on A and C, Cov ([A+ C],M) = Cov (B,M)

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©R. Schwartz Equity Markets: Trading and StructureSlide 5 A Stock and it s Replicating Portfolio Stocks (portfolios) with the same covariance should be priced to yield the same expected return, E(r i ) If E(r i ) is too high, P i is too low vis-à-vis the replicating portfolio If E(r i ) is too low, P i is too high vis-à-vis the replicating portfolio Any price divergence between a stock and its replicating portfolio will be arbitraged away Arbs are the source of infinite liquidity in a CAPM world

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©R. Schwartz Equity Markets: Trading and StructureSlide 6 Information Needed in the Frictionless World Stock Returns: Means Variances Covariances (cross-sectional)

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©R. Schwartz Equity Markets: Trading and StructureSlide 7 The Efficient Market Hypothesis (EMH) Existing information cannot be exploited to realize above normal (risk adjusted) trading profits Weak form information = historical market information Semi-strong form information = weak form + publicly available info Strong form Information= semi-strong form + private info = the complete information set

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©R. Schwartz Equity Markets: Trading and StructureSlide 8 Random Walk If the EMH holds Security price changes (returns) are not serially correlated Security price changes (returns) are not serially correlated R i,t f(R i,t-1 )

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©R. Schwartz Equity Markets: Trading and StructureSlide 9 What is Risk? Stock Returns: Variances Covariances (cross-sectional)

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©R. Schwartz Equity Markets: Trading and StructureSlide 10 Illiquidity, Information & Expectations

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©R. Schwartz Equity Markets: Trading and StructureSlide 11 Risk vs (IL)Liquidity Against the Gods: The Remarkable Story of Risk, Peter L. Bernstein Against the Devil: The Remarkable Story of Liquidity (Just a title) Lets start at the beginning (it has to do with information)

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©R. Schwartz Equity Markets: Trading and StructureSlide 12 Information Classification #1 Market info Fundamental info Classification #2 Public info Inside info Private info

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©R. Schwartz Equity Markets: Trading and StructureSlide 13 Ω, The Information Set Information is Vast, Complex and Imprecise Yet, we can trivialize it. Here is…

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©R. Schwartz Equity Markets: Trading and StructureSlide 14 6 Blind Men & An Elephant

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©R. Schwartz Equity Markets: Trading and StructureSlide 15 Expectations Based on Information Three possible situations: Investors have homogeneous expectations There is asymmetric information Investors have divergent expectations based on information that they all possess Question Under which scenario will liquidity be greatest?

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©R. Schwartz Equity Markets: Trading and StructureSlide 16 Liquidity: What is it? Difficult to define & measure but – You know when its not there Ability to trade in reasonable size, at a reasonable price, in a reasonable amount of time Without sufficient liquidity, a market will not function A quick operational definition: Lots of orders on the book Lots of order flow

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©R. Schwartz Equity Markets: Trading and StructureSlide 17 Some Better Definitions Depth and breadth Resiliency Market cap and trading volume Bid-ask spread Accentuated intra-day volatility

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©R. Schwartz Equity Markets: Trading and StructureSlide 18 Intra-Day Volatility

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©R. Schwartz Equity Markets: Trading and StructureSlide 19 INTRADAY VOLATILITY NYSE The First 1/2 Hour

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©R. Schwartz Equity Markets: Trading and StructureSlide 20 INTRADAY VOLATILITY NASDAQ The First 1/2 Hour

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©R. Schwartz Equity Markets: Trading and StructureSlide 21 INTRADAY VOLATILITY LONDON STOCK EXCHANGE The First 1/2 Hour

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©R. Schwartz Equity Markets: Trading and StructureSlide 22 INTRADAY VOLATILITY EURONEXT PARIS The First 1/2 Hour

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©R. Schwartz Equity Markets: Trading and StructureSlide 23 INTRADAY VOLATILITY DEUTSCHE B Ö RSE The First 1/2 Hour

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©R. Schwartz Equity Markets: Trading and StructureSlide 24 U-Shaped Intra-Day One-Minute Volatility* * Market Structure and Intra-day Price Behavior: An Event Study on Nasdaqs Crosses, Pagano, Peng and Schwartz, 2008, working paper w 60 bps Feb 2004 (Pre-Calls)

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©R. Schwartz Equity Markets: Trading and StructureSlide 25 U-Shaped Intra-Day 10-Second Volatility* * Market Structure and Intra-day Price Behavior: An Event Study on Nasdaqs Crosses, Pagano, Peng and Schwartz, 2008, working paper 40 bps Feb 2004 (Pre-Calls) 5 Min After Opening 5 Min Before Close

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©R. Schwartz Equity Markets: Trading and StructureSlide 26 What Explains This Volatility? Transaction costs Explicit costs Execution costs (See pages 64 – 69) Price discovery Quantity discovery In a Word Illiquidity

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©R. Schwartz Equity Markets: Trading and StructureSlide 27 Other Issues

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©R. Schwartz Equity Markets: Trading and StructureSlide 28 Origins of Liquidity Continuous order-driven market Periodic call auctions Quote driven markets Negotiated trades Hybrid markets A Bottom Line Market Structure Effects Liquidity

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©R. Schwartz Equity Markets: Trading and StructureSlide 29 Illiquidity s Footprints in Transaction Records Relevant Concepts: Intertemporal correlation Autocorrelation Serial correlation First order autocorrelation Higher order autocorrelation Serial cross-correlation

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©R. Schwartz Equity Markets: Trading and StructureSlide 30 Autocorrelation and Market Factors Sequential information arrival Limit order book Market maker intervention Inaccurate price discovery Bid-ask spread Market impact Non-synchronous price adjustment across stocks Correlation: what kind? Market Factor +,-, or what?

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©R. Schwartz Equity Markets: Trading and StructureSlide 31 How Do The Following Affect How Frequently You Trade? High explicit trading costs (commissions and fees) High implicit costs (bid-ask spreads and market impact) Accentuated intra-day volatility Capital gains taxes A feeling that our markets are not fair, that others participants will benefit at your expense A feeling that prices adjust so quickly to news that you will never be able to buy profitably when there is good news, or will be unable to cut your losses by selling before the market has fully responded to bad news

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©R. Schwartz Equity Markets: Trading and StructureSlide 32 Liquidity and Network Externalities Network examples Fax machines Microsoft Word An equities market Network externalities Order flow attracts order flow Network externalities, market size, and liquidity The most important determinant of the quality of a market is its size

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©R. Schwartz Equity Markets: Trading and StructureSlide 33 What Do the Following Have in Common? Without Gas, Neither Will Run

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