Financial Market Design & the Equity Premium Electronic Versus Floor Trading, Jain
-
Upload
eleanor-rigby -
Category
Documents
-
view
7 -
download
0
Transcript of Financial Market Design & the Equity Premium Electronic Versus Floor Trading, Jain
Jain, Pankaj K., 2005,
“Financial market design and the equity premium: Electronic vs. floor trading
,” Journal of Finance 60, 6, 2955-2985.
Floor versus Electronic
Market Design and Cost of Equity
Better Institutional features on Stock Exchanges
Improved Liquidity, lower spreads, higher turnover, better information
Lower illiquidity premium; Lower long term cost of equity for listed Firms
Literature Review Floor ElectronicTransaction costs and expected returns: Amihud et al (1986, 97)
Constantinides (1986), Vayanos (1998) 2nd order
Venkataraman (2001 JF): NYSE vs Paris;
Schmidt et al (1993): Germany; Jain (2001)
Muscarella & Piwowar (2001), Kalay et al (JF 2002): Paris/Israel, Domowitz & Stiel (2001) Barclay et al 1998Chiyachantana et al (2004)
Order Flow Transparency and Information
Limit orders hidden; Front running: Chung and Postelnicu (2003)
Better price discovery = better asset prices. O’hara et al (2002, 03), Ellul et al (2004)
Trader identity and adverse selection
Beneviste et al (1992): Repeated face to face interaction = reputation
Trader identity can be hidden. Jain et al (2004): LSE parallel markets
Liquidity factor is priced
Brennan & Subra (1996), Pastor & Stambaugh (2001)
Facilitates program trading: increases correlations
Competition Few market makers Numerous value traders
Floor versus Electronic• Face to Face• Order flow hidden• Best quotes only• Quotes evaporate• Slower execution• Slower settlement• Higher operating cost• Higher transaction cost• Expensive remote access• Reliance on single/few
market makers
• Trader identity can be hidden• Order flow displayed• All quotes• Quotes firm till withdrawn• Faster execution• Faster settlement• Cheaper• Deeply discounted brokerage• Better accessibility• Competition from numerous
value trades
Headline StoriesWall Street Journal 4/18/03 Financial Times (FT) 4/21/03
“Specialists at NYSE face probes of abuses: A lack of automation raises fresh suspicions of manipulation of trades (front-running),
FT, London Ed., Nov 28, 1997“Frankfurt exchange: Xetra electronic trading system goes live today:
"a new dimension" in bourse efficiency and transparency. .” Xetra will cut dealing costs and increase liquidity in German shares by automatically matching buyers and sellers. Xetra will make it easier to spot transgressions such as insider trading. "Market integrity is the most important asset on a stock market," "It means more fair play."
FT (London): Sep 18, 1992Survey of Pakistan: Foreign brokerages complain that since most local
broking houses are also stock jobbers, the lack of transparency in the marketplace provides ample room for abuse on the quoting of prices. With computer-assisted trading, the information flow is more rapid.
THE Karachi stock exchange was shut down yesterday after securities traders smashed windows and computers in protest at plans to end floor-trading making 2,000 dealers jobless.
Financial Market Design: Impact on Liquidity, Equity Premium, and Short Term Price Reaction
Hypotheses:
H10 : Electronic trading improves liquidity and
information. This reduces the cost of equity for listed firms in the long-run.
H20 : There is positive short-term price reaction to the
switch from floor to electronic trading (lower illiquidity premium reduces the discounting factor.)
H30 : The above effects vary by financial market
environment.
New Time Series Data (Dates) for 120 countries:
•Time series before AND after from MSCI, Datastream, IFC, www - Stock market indices (71), dividend yields (53), turnover (63 countries)
Methodology– Descriptive statistics; Multivariate regressions– Dividend growth model and International capital asset pricing model with
time varying betas using GARCH– Event study to examine short term effects
Country Estab. Elec. Annc. Source Data FreqInsider Liberal
1 Australia 1859 1987 1987 Handbook 94 1969 Monthly 1996 1969
2 Austria 1771 1996 1995 Handbook 01 1969 Monthly No 1969
3 Belgium 1801 1996 1993 Handbook 98 1969 Monthly 1994 1969
4 Canada 1878 1977 N.A. [email protected] 1969 Monthly 1905 1969
5 Denmark 1919 1988 1987www.xcse.dk/uk/kf/historie 1969 Monthly 1996 1969
6 ….. … contd…
Figure 1. The Global Shift from Floor Trading to Electronic TradingBased on the leading stock exchange in 118 countries from 1975 to 2001
Fully ElectronicCombined Floor and Electronic
Floor Trading Only
0
20
40
60
80
100
120
140
1975
1976
1977
1978
1979
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
Year
Nu
mb
er o
f E
xch
ang
es
Figure 2. Declining Cost of Equity and Improving Liquidity after Automation
0.79%
0.02%
0.25%
0.38%
0.79%
2.14%
0.22%
1.05%
1.57%
0.85%
1.46%
2.00%
2.61%
2.36%
0.26%
-0.17%
6.14%
-1.00% 0.00% 1.00% 2.00% 3.00% 4.00% 5.00% 6.00% 7.00%
Trading turnover
Volatility (Variance of returns)
Country minus t-bill return ($)
Country minus world return ($)
Country minus world return (localcurr)
Div. yield + Capital gains (U.S. $)
Div. yield + Cap. gain (local curr.)
Dividend yield + growth
Dividend yield
Floor Trading
Electronic Trading
9.24%
County by County Analysis
Country DY DYCG DYCG$ DYG ERW$ ERT Turnover
1 Australia -0.04% -1.52% -1.13% -1.76% -0.30% -0.82% 0.0253
2 Austria 0.01% -0.46% -1.19% -0.01% -0.84% -1.14% 0.3063
3 Belgium -0.17% 0.06% -0.88% -0.83% -0.38% -0.83% 0.1724
4 Canada -0.08% 0.79% 0.45% -0.46% -0.41% 0.18% 0.0291
5 Denmark -0.10% -0.19% 0.27% 0.75% 0.80% 0.59% 0.0375
6 …. …contd..
Proportion (-) 72% 82% 83% 62% 72% 82% 25%
Wilcoxon Rank Sum Test
U 1195 1263** 1139** 1279 1694** 1172** 2817**
Z -1.62 -5.13 -5.64 -0.47 -3.37 -5.50 2.91
More Evidence on Improvements in Liquidity
• Table 1: Turnover
• Jain (2001, companion working paper): retail spreads• Chiyachantana, Jain, Jiang, and Wood (forthcoming JF)
– Institutional trading costs (price impact and commisions)
• Ellul, Holden, Jain, and Jennings (2003, N.B.E.R./ Morgan Stanley working paper) – Direct Plus executions are faster but not costly.
• Jain, Jiang, McInish, and Taechapiroontong (2003)– London dealers versus SETS: No reputation effects from face
to face trading
• Anecdotal Evidence: BSE versus NSE in India
ICAPM(returnit–rft)= 0 + covhiwt + (1-)varhit +eit
• Estimate betas and prices for world market risk and local variance risk allowing for time varying integration of the markets with the world.
• ARCH model (returnit–rft) = c1 + it,(worldt –rft) = c2 + wt,
hit = b1 + a1(1/22
it-1 + 1/32it-2 + 1/62
it-3),
hiw = b2 + a2(1/22
wt-1 + 1/32wt-2 + 1/62
wt-3),
hiwt = b3 + a3(1/2it-1wt-1 + 1/3it-2wt-2 + 1/6it-3wt-3),
• If risk factors explained equity premium completely, then residuals should be orthogonal to other variables. Regress residuals eit on Automation and other variables
wtiwt
iwtitwtit hh
hhN ,
0
0~,
Table 4. Effect of Electronic Trading: ICAPM with Time Varying Betas
A. Dependent variable is excess returns
Parameters Coefficient Std. Error P-Value
Alpha 0.0040 0.0011 <.0001
Price of world covariance risk 4.3927 1.8419 0.0171
Price of own-country variance risk 1.3015 0.1147 <.0001
B. Dependent Variable -> Residuals from ICAPM model
Independent Variables Coeff. Std. Error P-Value
Intercept 0.0006 0.0132 0.9617
Electronic Trading -0.0046 0.0023 0.0411
Enforcement of Insider trading laws -0.0025 0.0020 0.1964
Liberalization -0.0038 0.0025 0.1280
Market Capitalization -0.0010 0.0009 0.2928
Developed Markets 0.0015 0.0024 0.5431
Time Trend 0.0001 0.0004 0.7150
B 2. Interaction between electronic trading and level of economic development.
Intercept 0.0025 0.0011 0.0300
Electronic * Developed -0.0036 0.0020 0.0762
Electronic * Emerging -0.0069 0.0021 0.0008
Impact of Automation on cost of equity with time varying risk using ICAPM: Different time horizons
before and after
years Parm. Est. Std. Error t-stat P-value
full -0.00450 0.00230 -1.98 0.0471
10 -0.00656 0.00240 -2.73 0.0063
5 -0.00613 0.00273 -2.25 0.0245
3 -0.00497 0.00317 -1.57 0.1170
Figure 3. Cumulative Excess-over-world Returns
-5%
0%
5%
10%
15%
20%
25%
30%
-24
-23
-22
-21
-20
-19
-18
-17
-16
-15
-14
-13
-12
-11
-10 -9 -8 -7 -6 -5 -4 -3 -2 -1 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24
Month Relative to Announcement/ Implementation of Fully Automated Trading
Exc
ess
Cou
ntry
Ret
urn
Min
us E
xces
s W
orld
Ret
urns
..
Implementation
Announcement
Illiquidity Equity-Premium Studies: A comparisonStudy Reason Premium
This paper Lower liquidity on floor 5.35% pa
Pastor & Stambaugh(2001)
Higher sensitivity to market liquidity 7.50% pa
Bhattacharya-Daouk(2002) Illiquidity due to insider trading 7.00% pa
Illiquidity Price-Discount Studies: A comparison
Study Reason Discount
This paper Price reaction on Switch 6.27%
Silber (1991) Stocks with 2-year lock-in 30.00%
Loderer and Roth (2001)
Stocks with higher bid-ask spreads
35.00%
Dimson and Hanke (2000)
Equity linked bonds 9.00%
Robustness of Results• Switch dates cross checked from 3 sources in 70% cases.
– MSCI handbook of world’s stock exchanges, Website of exchange, Email/Snail mail/Literature directly from exchanges
• Results are Robust to additional analysis:– by sub-samples like full history, 10, 5, 3 years – Gross Returns, Excess over World, Excess over Risk
free returns.– Drop internet boom & bust period 01/99 to 06/01– Allow for transition period of 1 or 2 years.
• Control Variables– Liberalization, Enforcement of Insider law, Level of
World returns, developed vs. emerging markets, Time varying risk factors, a Trend variable.
• Cost of equity reduces by 0.31%/month after automation
– Sharper results with ICAPM model than with dividend growth – Reduction comparable to those due to liberalization, lower systematic
liquidity, and insider trading enforcement
• 59 out of 71 countries (83%) that switch experience reduction
• Bigger effect in emerging markets than in developed
• Positive price reaction of 7.87% in announcement month
• Annual trading turnover increases by 37% of market cap
• Bid ask spreads drop by 40% (based on a smaller sample)
Paper available at: http://www.people.memphis.edu/~pjain/automate.pdf
Summary of Results & Conclusions: Floor vs Electronic