High Frequency Trading and Price Discovery

45 Pages Posted: 20 Jul 2012 Last revised: 1 Aug 2012

Jonathan Brogaard

University of Washington - Department of Finance and Business Economics

Terrence Hendershott

University of California, Berkeley - Haas School of Business

Ryan Riordan

Queen's School of Business

Date Written: July 30, 2012

Abstract

We examine the role of high-frequency traders (HFT) in price discovery and price efficiency. Overall HFT facilitate price efficiency by trading in the direction of permanent price changes and in the opposite direction of transitory pricing errors on average days and the highest volatility days. This is done through their marketable orders. In contrast, HFT liquidity-supplying non-marketable orders are adversely selected in terms of the permanent and transitory components as these trades are in the direction opposite to permanent price changes and in the same direction as transitory pricing errors. HFT predicts price changes in the overall market over short horizons measured in seconds. HFT is correlated with public information, such as macro news announcements, market-wide price movements, and limit order book imbalances.

Keywords: high frequency trading, price formation, price discovery, pricing errors

JEL Classification: G12

Suggested Citation

Brogaard, Jonathan and Hendershott, Terrence and Riordan, Ryan, High Frequency Trading and Price Discovery (July 30, 2012). AFA 2013 San Diego Meetings Paper. Available at SSRN: https://ssrn.com/abstract=1938769 or http://dx.doi.org/10.2139/ssrn.1938769

Jonathan Brogaard (Contact Author)

University of Washington - Department of Finance and Business Economics ( email )

Box 353226
Seattle, WA 98195
United States

Terrence J. Hendershott

University of California, Berkeley - Haas School of Business ( email )

545 Student Services Building, #1900
2220 Piedmont Avenue
Berkeley, CA 94720
United States

Ryan Riordan

Queen's School of Business ( email )

Smith School of Business, Queen's University
143 Union Street
Kingston, Ontario K7L 3N6
Canada

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