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Abstract:
We assess the informational content of an open limit order book from three directions: (1) Does the limit order book allow better inferences about a security's value than simply the best bid and offer prices from the first step of the book? If it does, how much additional information can be gleaned from the book? (2) Are imbalances between the demand and supply schedules informative about future price movements? and (3) Does the shape of the limit order book impact traders' order submission strategies? Our empirical evidence suggests that the order book beyond the first step is informative - its information share is about 30%. The imbalance between demand and supply from step 2 to 10 provides additional power in explaining future short-term returns. Finally, traders do use the available information on the state of the book, not only from the first step, but also from other steps, when developing their order submission strategies.

Limit order book, price discovery, order placement strategy, demand and supply

Abstract:
We test the hypothesis that insider trading impairs market liquidity, by analyzing intraday trades and quotes around 1,497 IPO lockup expirations in the period 1995-1999. We find that, while lockup expirations are associated with considerable insider trading for some IPO firms, they have little effect on effective spreads. By contrast, two other liquidity measures, quote depth and trading activity, improve substantially. In the 23% of lockup expirations where insiders disclose share sales, spreads actually decline. These findings indicate that a large body of well-informed, blockholding insider traders can enter a market from which they had previously been absent, and substantially change trading volume and share price, without impairing market liquidity.

Initial Public Offerings, Lockups, Insider Trading

Abstract:
We test the hypothesis that insider trading impairs market liquidity, by analyzing intraday trades and quotes around 1,497 IPO lockup expirations in the period 1995-1999. We find that, while lockup expirations are associated with considerable insider trading for some IPO firms, they have little effect on effective spreads. By contrast, two other liquidity measures, quote depth and trading activity, improve substantially. In the 23% of lockup expirations where insiders disclose share sales, spreads actually decline. These findings indicate that a large body of well-informed, blockholding insider traders can enter a market from which they had previously been absent, and substantially change trading volume and share price, without impairing market liquidity.

Initial Public Offerings, Lockups, Insider Trading

Abstract:
Distinct from the market-index, most individual firms' risk-neutral return distributions share three characteristics: they are far more volatile, substantially less negatively-skewed, and more leptokurtotic. But, what are the implications of these properties for models of individual equity options? We present and empirically investigate a double-jump option-pricing model that allows for stochastic volatility, return-jumps, volatility-jumps, and admits many existing models as special cases. Using a sample of 100 most active firms on the CBOE, we find that (i) the double-jump process is the least misspecified and the least demanding in fitting the tail-size and tail-asymmetry of the individual return distributions; (ii) the double-jump model improves pricing performance beyond return-jumps absent volatility-jumps, and beyond volatility-jumps absent return-jumps; and (iii) between return-jumps and volatility-jumps, the former is empirically more relevant than the latter for pricing options. The inverse link between volatility-jumps and return-jumps is instrumental for reconciling the valuation of deep out-of-money options. Compared to risk-neutral skewness, the excess kurtosis is, by far, a more crucial determinant of the cross-section of pricing-errors, especially for puts.

risk-neutral kurtosis, return-jumps, volatility-jumps, stochastic volatility, individual equity option-models, option-implied return distributions

Abstract:
We explore the connection between the market for single-name credit default swaps (CDS) and the market for individual stock options. We find that the contemporaneous link between CDS spreads and option-implied volatilities is stronger among firms with lower credit ratings, higher CDS spread volatilities, and more actively traded options. Among such firms, the changes in both CDS spreads and implied volatilities forecast future stock returns. Although the changes in implied volatility consistently forecast future CDS spread changes, the reverse does not hold. We interpret these findings as broadly consistent with informed traders preferentially using the options market, and to some extent the CDS market, to exploit their information advantage. Although implied volatility dominates historical volatility in forecasting the future realized volatility on individual stocks, the volatility risk premium embedded in option prices also plays a crucial role in explaining CDS spreads. Our results are robust under a pricing analysis using a structural credit risk model. They are also unaffected by historical volatilities estimated at short or long horizons.

Credit default swap spread, option-implied volatility, volatility risk premium, informed trading

Abstract:
This paper examines the information embedded in both the stock and option markets prior to takeover announcements. During normal periods, buyer-seller initiated stock volume imbalances are significant predictors of next-day stock returns and option volume imbalances are uninformative. However, prior to takeover announcements, call volume imbalances are strongly positively related to next-day stock returns. Cross-sectional analysis shows that those takeover targets with the largest
pre-announcement call-imbalance increases experience the highest announcement-day returns. The largest increase in
buyer-initiated trading activity is in short-term
out-of-the-money calls that subsequently experience the largest returns. Collectively, these findings are consistent with the hypothesis that, in the presence of pending extreme informational events, the options market plays an important role in price discovery.

Abstract:
We study the dynamic relation between aggregate mutual fund flow and market-wide volatility. Using daily flow data and a VAR approach, we find that market volatility is negatively related to concurrent and lagged flow. A structural VAR impulse response analysis suggests that shock in flow has a negative impact on market volatility: An inflow (outflow) shock predicts a decline (an increase) in volatility. From the perspective of volatility-flow relation, we find evidence of volatility timing for recent period of 1998-2003. Finally, we document a differential impact of daily inflow versus outflow on intraday volatility. The relation between intraday volatility and inflow (outflow) becomes weaker (stronger) from morning to afternoon.

Mutual fund flow, Market volatility, Volatility timing, Fund inflow and fund outflow

Abstract:
We study whether mutual fund managers successfully time market liquidity. Using a model assuming that fund managers attempt to maximize fund shareholders’ utility by timing market exposure, we motivate liquidity timing from the fund manager’s perspective. Fund managers reduce market exposure in illiquid markets and increase market exposure in liquid markets. Liquidity timing is persistent and predicts the funds’ risk-adjusted performance in the next period. Successful liquidity timers tend to have longer history and higher turnover rate, and attract more flows from investors.

Market Liquidity, Liquidity Timing, Mutual Fund Performance, Fund Flow

Abstract:
While recent studies document increasing idiosyncratic volatility over the past four decades, an explanation for this trend remains elusive. We establish a theoretical link between growth options available to managers and the idiosyncratic risk of equity. Empirically both the level and variance of corporate growth options are significantly related to idiosyncratic volatility. Accounting for growth options eliminates or reverses the trend in aggregate firm-specific risk. These results are robust for different measures of idiosyncratic volatility, different growth option proxies, across exchanges, and through time. Finally, our results suggest that growth options explain the trend in idiosyncratic volatility beyond alternative explanations.

Abstract:
While recent studies document increasing idiosyncratic volatility over the past four decades, an explanation for this trend remains elusive. We establish a theoretic link between growth options available to managers and the idiosyncratic risk of equity. Empirically both the level and variance of corporate growth options are significantly related to idiosyncratic volatility. Accounting for growth options eliminates or reverses the trend in aggregate firm specific risk. These results are robust for different measures of idiosyncratic volatility, different growth option proxies, across exchanges, and through time. Finally, our results suggest that growth options explain the trend in idiosyncratic volatility beyond alternative explanations.

Idiosyncratic volatility, growth options, real options

Abstract:
Several recent studies present evidence of investor misreaction in the options market. While the interpretation of their results is still controversial, we note that the important question of economic significance has not been fully addressed. We fill in this gap by formulating regression-based tests to identify misreaction and its duration and constructing trading strategies to exploit the empirical patterns of misreaction. Using regular S&P 500 index options and long-dated S&P 500 LEAPS, we find an underreaction that on average dissipates over the course of three trading days and an increasing misreaction that peaks after four consecutive daily variance shocks of the same sign. Option trading strategies based on these findings produce economically significant abnormal returns in the range of one to three percent per day. However, they are not profitable in the presence of transaction costs.

Abstract:
This paper studies Nasdaq market makers' activities during the one-and-half hour pre-opening period. Price discovery during the pre-opening is conducted via price signaling as opposed to the auction used to open the NYSE or the continuous market used during trading. In the absence of trades, Nasdaq dealers use crossed and locked inside quotes to signal to other market makers which direction the price should move. Furthermore, we find evidence of price leadership among market makers that bears little resemblance to their IPO/SEO lead underwriter participation.

Abstract:
This paper studies Nasdaq market makers' activities during the one-and-half hour pre-opening period. Price discovery during the pre-opening is conducted via price signaling as opposed to the auction used to open the NYSE or the continuous market used during trading. In the absence of trades, Nasdaq dealers use crossed and locked inside quotes to signal to other market makers which direction the price should move. Furthermore, we find evidence of price leadership among market makers that bears little resemblance to their IPO/SEO lead underwriter participation.

Abstract:
This article empirically analyzes some properties shared by all one-dimensional diffusion option models. Using S&P 500 options, we find that when sampled intraday (or inter-day), (i) call (put) prices often go down (up) even as the underlying price goes up, and (ii) call and put prices often increase, or decrease, together. Our results are valid after controlling for time-decay and market microstructure effects. Therefore, one-dimensional diffusion option models cannot be completely consistent with observed option-price dynamics; options are not redundant securities, nor ideal hedging instruments---puts and the underlying asset prices may go down together.

Abstract:
The AMEX changed the tick size from $1/8 to $1/16 for low-price stocks on September 3, 1992. Consistent with the prediction of L. E. Harris (1994, Stock Price Clustering and Discreteness, Review of Financial Studies 7, 149-178), the change has reduced both quoted and effective spreads, although the magnitude of the reduction is much smaller than predicted. However, we fail to find evidence of a significant increase in trading volume. Our cross-sectional analysis shows that stocks with greater trading activity, lower prices and stronger competition from the regional exchanges experienced greater spread reductions.

Abstract:
Recent empirical studies find that once an option pricing model has incorporated stochastic volatility, allowing interest rates to be stochastic does not improve pricing or hedging any further while adding random jumps to the modeling framework only helps the pricing of extremely short-term options but not the hedging performance. Given that only options of relatively short terms are used in existing studies, this paper addresses two related questions: Do long-term options contain different information than short-term options? If so, can long-term options better differentiate among alternative models? Our inquiry starts by first demonstrating analytically that differences among alternative models usually do not surface when applied to short term options, but do so when applied to long-term contracts. For instance, within a wide parameter range, the Arrow-Debreu state price densities implicit in different stochastic-volatility models coincide almost everywhere at the short horizon, but diverge at the long horizon. Using regular options (of less than a year to expiration) and LEAPS, both written on the S&P 500 index, we find that short- and long-term contracts indeed contain different information and impose distinct hurdles on any candidate option pricing model. While the data suggest that it is not as important to model stochastic interest rates or random jumps (beyond stochastic volatility) for pricing LEAPS, incorporating stochastic interest rates can nonetheless enhance hedging performance in certain cases involving long-term contracts.

Abstract:
Substantial progress has been made in extending the Black-Scholes model to incorporate such features as stochastic volatility, stochastic interest rates and jumps.On the empirical front, however, it is not yet known whether and by how much each generalized feature will improve option pricing and hedging performance. This paper fills this gap by first developing an implementable option model in closed form that allows volatility, interest rates and jumps to bestochastic and that is parsimonious in the number of parameters. The model includes many known ones as special cases. Delta-neutral and single-instrument minimum-variance hedging strategies are derived analytically. Using S&P 500 options, we examine a set of alternative models from three perspectives: (1) internal consistency of implied parameters/volatility with relevant time-series data, (2)out-of-sample pricing and (3) hedging performance. The models of focus include the benchmark Black-Scholes formula and the ones that respectively allow for (i) stochastic volatility, (ii) both stochastic volatility and stochastic interest rates, and (iii) stochastic volatility and jumps.Overall, incorporating both stochastic volatility and random jumps produces the best pricing performance and the most internally-consistent implied-volatility process. Its implied volatility does not "smile" across moneyness. But, for hedging, adding either jumps or stochastic interest rates does not seem to improve performance any further once stochastic volatility is taken into account.

Abstract:
Substantial progress has been made in extending the Black- Scholes model to incorporate such features as stochastic volatility, stochastic interest rates and jumps. On the empirical front, however, it is not yet known whether and by how much each generalized feature will improve option pricing and hedging performance. This paper fills this gap by first developing an implementable option model in closed form that allows volatility, interest rates and jumps to be stochastic and that is parsimonious in the number of parameters. The model includes many known ones as special cases. Delta- neutral and single-instrument minimum-variance hedging strategies are derived analytically. Using S&P 500 options, we examine a set of alternative models from three perspectives: (1) internal consistency of implied parameters/ volatility with relevant time-series data, (2) out-of-sample pricing and (3) hedging performance. The models of focus include the benchmark Black-Scholes formula and the ones that respectively allow for (i) stochastic volatility, (ii) both stochastic volatility and stochastic interest rates, and (iii) stochastic volatility and jumps. Overall, incorporating both stochastic volatility and random jumps produces the best pricing performance and the most internally-consistent implied-volatility process. Its implied volatility does not "smile" across moneyness. But, for hedging, adding either jumps or stochastic interest rates does not seem to improve performance any further once stochastic volatility is taken into account.

Abstract:
The Toronto Stock Exchange (TSE) switched from a fractional to a decimal trading system on April 15, 1996. This paper examines the impact of decimalization on the competition for order flows between Canadian and U.S. exchanges by analyzing TSE stocks cross-listed on U.S. exchanges. We find that order flows do not migrate from U.S. exchanges to the TSE, although the effective spreads declined by 16-27% for cross-listed stocks traded on the TSE. For TSE stocks traded on the NYSE and AMEX, there is no change in the spread and trading volume, while TSE stocks traded on Nasdaq experienced a 8% spread reduction but no change in trading volume. Our results are consistent with the hypotheses that (1) the savings in transaction costs on the TSE are not sufficient to offset the benefits of trading on the NYSE and AMEX and that (2) Nasdaq dealers might not operate as efficiently as perfect competition warrants.

Abstract:
This paper tests for differences in execution costs among specialist firms for NYSE listed securities. Execution cost differences provide a useful measure of the relative performance of specialist firms. We find a substantial difference in effective spreads and order processing costs across specialist firms, controlling for stock characteristics. While economically significant, the differences in execution costs between specialist firms are much smaller than the cross-market differences reported by Huang and Stoll (1996). Within a specialist firm, there is a positive relation between order processing costs and trading activity which is consistent with the hypothesis that active stocks subsidize inactive stocks.