What moves stock prices? The role of news, noise, and information (with Thanh Huong Nguyen, Talis Putnins, and Eliza Wu) 2021. Review of Financial Studies, forthcoming. Abstract
We develop a return variance decomposition model to separate the role of different types of information and noise in stock price movements. We disentangle four components: market-wide information, private firm-specific information revealed through trading, firm-specific information revealed through public sources, and noise. 31% of the return variance is from noise, 37% from public firm-specific information, 24% from private firm-specific information and 8% from market-wide information. Since the mid 1990s there has been a dramatic decline in noise. During this period firm-specific information is increasing, consistent with increasing market efficiency. Our findings help reconcile the mixed results in the R^2 literature.
Dark pool trading and information acquisition (with Jing Pan) 2021. Review of Financial Studies, forthcoming. Abstract
Theory suggests that dark pools may facilitate or discourage information acquisition. We find that more dark pool trading leads to greater information acquisition. We measure information acquisition using stock price dynamics around earnings announcements. To overcome endogeneity concerns, we exploit a large exogenous decrease to dark pool trading that results from the implementation of the Security and Exchange Commission’s (SEC’s) Tick Size Pilot Program. The results cannot be explained by lit venue liquidity, algorithmic trading, or informational efficiency. A battery of additional tests, such as documenting a shift in SEC EDGAR searches, supports the information acquisition interpretation.
Political influence and the renegotiation of government contracts (with Matthew Denes and Ran Duchin) 2021. Review of Financial Studies, 34(4): 3095-3137. Abstract
This paper provides novel evidence that corporate political influence operates through renegotiations of existing government contracts. Using detailed data on contractual terms and renegotiations around sudden deaths and resignations of local politicians, the estimates show that politically connected firms initially bid low and successfully renegotiate contract amounts, deadlines, and incentives. The effects hold across different industries and contract types, enhance firm value, and persist around the exogenous increase in contract supply due to the American Recovery and Reinvestment Act of 2009. Overall, this paper puts forth an unexplored link between political influence, ex-post renegotiations and ex-ante bidding of government contracts.
A BIT goes a long way: Bilateral investment treaties and cross-border mergers (with Vineet Bhagwat and Brandon Julio) 2021. Journal of Financial Economics, 140(2): 514-538. Abstract
We examine whether Bilateral Investment Treaties (BITs), an external governance mechanism, stimulate cross-border mergers by protecting the property rights of foreign acquirers. Exploiting the staggered adoption and bilateral nature of the treaties, we find that BITs have a large positive effect on cross-border mergers. The probability and dollar volume of mergers between two given countries more than doubles after the signing of a BIT. The increase is driven by deals flowing from developed economies to developing economies and is concentrated in target countries with medium levels of political risk. The results suggest BITs are effective in expanding the global market for corporate control, particularly in the developing world.
Global political uncertainty and asset prices (with Lili Dai, Phong Ngo, and Bohui Zhang) 2020. Review of Financial Studies, 33(4): 1737-1780. Abstract
We show that global political uncertainty, measured by the U.S. election cycle, on average, leads to a fall in equity returns in 50 non-U.S. countries. At the same time, market volatilities rise, local currencies depreciate, and sovereign bond returns increase. The effect of global political uncertainty on equity prices increases with the level of uncertainty in U.S. election outcomes, and a country’s equity market exposure to foreign investors, but does not vary with the country’s international trade exposure. These findings suggest that global political uncertainty causes an increase in investors’ aggregate risk aversion, leading to a flight to safer assets.
The economic impact of index investing (with Matthew Ringgenberg and David Sovich) 2019. Review of Financial Studies, 32(9): 3461-3499. Abstract
We study the impact of index investing on firm performance by examining the link between commodity indices and firms that use index commodities. Starting in 2004, there was a dramatic increase in commodity index investing, an event referred to as the financialization of commodity markets. Following financialization, firms that use index commodities make worse production decisions and earn lower profits. Consistent with a feedback channel in which market participants learn from prices, our results suggest that index investing in financial markets distorts the price signal thereby generating a negative externality that impedes firms' ability to make production decisions.
Price discovery without trading: Evidence from limit orders (with Terrence Hendershott and Ryan Riordan) 2019. Journal of Finance, 74(4): 1621-1658 (Lead Article).Abstract
Adverse selection in financial markets is traditionally measured by the correlation between the direction of market order trading and price movements. We show this relationship has weakened dramatically with limit orders playing a larger role in price discovery and with high-frequency traders’ (HFTs) limit orders playing the largest role. HFTs are responsible for 60–80% of price discovery, primarily through their limit orders. HFTs’ limit orders have 50% larger price impact than non-HFTs’ limit orders, and HFTs submit limit orders 50% more frequently. HFTs react more to activity by non-HFTs than the reverse. HFTs react more to messages both within and across stock exchanges.
High frequency trading competition (with Corey Garriott) 2019. Journal of Financial and Quantitative Analysis, 54(4): 1469-1497 (Lead Article). Abstract
Theory on high-frequency traders (HFT) predicts that market liquidity for a security decreases in the number of HFT trading the security. We test this prediction by studying a new Canadian stock exchange, Alpha, that experienced the entry of 11 HFT firms over four years. Bid-ask spreads on Alpha converge to those at the Toronto Stock Exchange as more HFT trade on Alpha. Effective and realized spreads for nonHFT improve as HFT firms enter the market. To explain the contrast with theoretical predictions we test the model assumption of price competition and reject it in favor of quantity competition.
Risk and return in high frequency trading (with Matthew Baron, Bjorn Hagstromer and Andrei Kirilenko) 2019. Journal of Financial and Quantitative Analysis, 54(3): 993-1024 (Lead Article). Abstract
We study performance and competition among high-frequency traders (HFTs). We construct measures of latency and find that differences in relative latency account for large differences in HFTs’ trading performance. HFTs that improve their latency rank due to colocation upgrades see improved trading performance. The stronger performance associated with speed comes through both the short-lived information channel and the risk management channel, and speed is useful for a variety of strategies including market making and cross-market arbitrage. We explore implications of competition on relative latency and find support for various theoretical predictions.
Do upgrade matter?: Evidence from trading volume (with Jennifer Koski and Andrew Siegel) 2018. Journal of Financial Markets, 43(1): 54-77. Abstract
Prior research documents no significant abnormal returns around upgrades of credit ratings, suggesting that upgrades do not convey new information. These tests are limited by lack of data, liquidity screens, and ambiguous predictions. We extend prior research using trading volume. Because volume is highly non-normally distributed (especially in the bond market), we derive a new, more powerful nonparametric test statistic that can be used in other applications. Our results show significant abnormal volume in both stock and bond markets around both upgrades and downgrades. Some of this volume is attributable to credit-ratings-based regulations and other factors. Controlling for other effects, we also find evidence that upgrade announcements contain information.
Institutions and deposit insurance: Empirical evidence (with Kathryn Dewenter and Alan Hess) 2018. Journal of Financial Services Research, 54(3): 269-292. Abstract
Do banks’ responses to changes in deposit insurance vary across countries even if the countries have comparable institutions? If so, by how much? Using data on the financial performance of large banks in 15 financially and economically developed countries, we find that where deposit insurance has an effect, it is large and varies depending on the level of economic freedom, rule of law and corruption in the bank’s home country. As in prior papers, we show that during stable economic periods, increases in deposit insurance are associated with higher bank risk, both problem loans and leverage. In most, but not all cases, stronger institutions temper these effects. The institutions’ effects are substantial. For example, average changes in the Rule of Law double the impact of a change in deposit insurance on bank leverage. We contribute to the substantial literature in this area by showing that the institutional effects are significant even across a set of countries with comparable institutions; by conducting a careful calibration of the economic significance of the effects; by providing evidence that during stable periods changes in deposit insurance only affect bank risk and not other measures of performance; and finally by showing that the effects of both deposit insurance and institutions vary across stable and crisis economic periods. The stable period results are consistent with the moral hazard effects of deposit insurance, while the crisis period results are consistent with endogeneity concerns that poor bank performance could drive changes in regulations.
Do economists swing for the fences after tenure? (with Joseph Engelberg and Ed van Wesep) 2018. Journal of Economic Perspectives, 32(1): 179-194. Abstract
Using a sample of all academics who pass through top 50 economics and finance departments from 1996 through 2014, we study whether the granting of tenure leads faculty to pursue riskier ideas. We use the extreme tails of ex-post citations as our measure of risk and find that both the number of publications and the portion consisting of “home runs” peak at tenure and fall steadily for a decade thereafter. Similar patterns hold for faculty at elite (top 10) institutions and for faculty who take differing time to tenure. We find the opposite pattern among poorly-cited publications: their numbers rise post-tenure.
High frequency trading and extreme price movements (with Ryan Riordan, Andriy Shkilko, Konstantin Sokolov, Allen Carrion, and Thibaut Moyaert) 2017. Journal of Financial Economics, 128(2): 253-265. Abstract
Are endogenous liquidity providers (ELPs) reliable in times of market stress? We examine the activity of a common ELP type – high frequency traders (HFTs) – around extreme price movements (EPMs). We find that on average HFTs provide liquidity during EPMs by absorbing imbalances created by non-high frequency traders (nHFTs). Yet HFT liquidity provision is limited to EPMs in single stocks. When several stocks experience simultaneous EPMs, HFT liquidity demand dominates their supply. There is little evidence of HFTs causing EPMs.
Stock liquidity and default risk (with Dan Li and Ying Xia). 2017. Journal of Financial Economics, 124(3): 486-502. Abstract
This paper examines the impact of stock liquidity on firm bankruptcy risk. Using the Securities and Exchange Commission’s decimalization regulation as a shock to stock liquidity, we establish that enhanced liquidity decreases default risk. Stocks with the highest default risk experience the largest improvements. We find two mechanisms through which stock liquidity reduces firm default risk: through improving stock price informational efficiency and facilitating corporate governance by blockholders. Of the two mechanisms, the informational efficiency channel has higher explanatory power than the corporate governance channel.
High frequency trading and the 2008 short sale ban (with Terrence Hendershott and Ryan Riordan). 2017. Journal of Financial Economics, 124(1): 22-42. Abstract
We examine the effects of high-frequency traders (HFTs) on liquidity using the September 2008 short sale-ban. To disentangle the separate impacts of short selling by HFTs and non-HFTs, we use an instrumental variables approach exploiting differences in the ban’s cross-sectional impact on HFTs and non-HFTs. Non-HFTs’ short selling improves liquidity, as measured by bid-ask spreads. HFTs’ short selling has the opposite effect by adversely selecting limit orders, which can decrease liquidity supplier competition and reduce trading by non-HFTs. The results highlight that some HFTs’ activities are harmful to liquidity during the extremely volatile short-sale ban period.
Trading fast and slow: Colocation and liquidity (with Bjorn Hagstromer, Lars Norden, and Ryan Riordan). 2015. Review of Financial Studies, 28(12): 3407-3443. Abstract
We exploit an optional colocation upgrade at NASDAQ OMX Stockholm to assess how speed affects market liquidity. Liquidity improves for the overall market and even for noncolocated trading entities. We find that the upgrade is pursued mainly by participants who engage in market making. Those that upgrade use their enhanced speed to reduce their exposure to adverse selection and to relax their inventory constraints. In particular, the upgraded trading entities remain competitive at the best bid and offer even when their inventories are in their top decile. Our results suggest that increasing the speed of market-making participants benefits market liquidity.
The asset pricing implications of government economic policy uncertainty (with Andrew Detzel). 2015. Management Science, 61(1): 3-18 (Lead Article). Abstract
Using the news-based measure of Baker et al. [Baker SR, Bloom N, Davis SJ (2013) Measuring economic policy uncertainty. Working paper, Stanford University, Stanford, CA] to capture economic policy uncertainty (EPU) in the United States, we find that EPU positively forecasts log excess market returns. An increase of one standard deviation in EPU is associated with a 1.5% increase in forecasted three-month abnormal returns (6.1% annualized). Furthermore, innovations in EPU earn a significant negative risk premium in the Fama–French 25 size–momentum portfolios. Among the Fama–French 25 portfolios formed on size and momentum returns, the portfolio with the greatest EPU beta underperforms the portfolio with the lowest EPU beta by 5.53% per annum, controlling for exposure to the Carhart four factors as well as implied and realized volatility. These findings suggest that EPU is an economically important risk factor for equities.
High-frequency trading and the execution costs of institutional investors (with Terrence Hendershott, Stefan Hunt, and Carla Ysusi). 2014. Financial Review, 49(2): 345-369 (Winner of the Outstanding Publication Award). Abstract
This paper studies whether high-frequency trading (HFT) increases the execution costs of institutional investors. We use technology upgrades that lower the latency of the London Stock Exchange to obtain variation in the level of HFT over time. Following upgrades, the level of HFT increases. Around these shocks to HFT institutional traders’ costs remain unchanged. We find no clear evidence that HFT impacts institutional execution costs.
High frequency trading and price discovery (with Terrence Hendershott and Ryan Riordan). 2014. Review of Financial Studies, 27(8): 2267-2306 (Lead Article and Winner of the Michael J. Brennan Best Paper Award). Abstract
We examine the role of high-frequency traders (HFTs) in price discovery and price efficiency. Overall HFTs facilitate price efficiency by trading in the direction of permanent price changes and in the opposite direction of transitory pricing errors, both on average and on the highest volatility days. This is done through their liquidity demanding orders. In contrast, HFTs' liquidity supplying orders are adversely selected. The direction of HFTs' trading predicts price changes over short horizons measured in seconds. The direction of HFTs' trading is correlated with public information, such as macro news announcements, market-wide price movements, and limit order book imbalances.
Network position and productivity: Evidence from journal editor rotations (with Joseph Engelberg and Christopher Parsons). 2014. Journal of Financial Economics, 111(1): 251-270. Abstract
Using detailed publication and citation data for over 50,000 articles from 30 major economics and finance journals, we investigate whether network proximity to an editor influences research productivity. During an editor's tenure, his current university colleagues publish about 100% more papers in the editor's journal, compared to years when he is not editor. In contrast to editorial nepotism, such “inside” articles have significantly higher ex post citation counts, even when same-journal and self-cites are excluded. Our results thus suggest that despite potential conflicts of interest faced by editors, personal associations are used to improve selection decisions.
Does floor trading matter? (with Matthew Ringgenberg and Dominik Rosch) Abstract
While algorithmic trading now dominates financial markets, some exchanges continue to use human floor traders. On March 23, 2020 the NYSE suspended floor trading because of COVID-19. Using a difference-in-differences analysis, we find that floor traders are important contributors to market quality, even in the age of algorithmic trading. The suspension of floor trading leads to higher effective and quoted spreads and larger pricing errors. Moreover, consistent with theoretical predictions about automation, the effects are strongest around the opening and closing auctions when complexity is highest. Our findings suggest that human expertise can complement algorithms in complex situations.
Machine learning and the stock market (with Abalfazl Zareei) Abstract
Practitioners allocate substantial resources to technical analysis whereas academic theories of market efficiency rule out technical trading profitability. We study this long-standing puzzle by applying a diverse set of machine learning algorithms. The results show that an investor can find profitable technical trading rules using past prices, and that this out-of-sample profitability decreases through time, showing that markets have become more efficient over time. In addition, we find that the evolutionary genetic algorithm’s attitude in not shying away from erroneous predictions gives it an edge in building profitable strategies compared to the strict loss-minimization-focused machine learning algorithms.
On the causal effect of fame on citations (with Joseph Engelberg, Sapnoti Eswar, and Edward Van Wesep) Abstract
Papers published in economics journals whose first authors are famous have more citations than papers whose second or third authors are famous. As a paper ages, its citation rate varies most with variation in the fame of the first author and less so with the fame of second and third authors. Author order is alphabetical so these patterns are unrelated to underlying quality. The magnitudes we find are large: a three-author paper written by the most prolific author in economics and his two research assistants would receive, on average, more than double the citations if the prolific author were first rather than second or third. The effect is especially pronounced in three, rather than two, author papers, suggesting that burying a famous author in the “et al” reduces citations even further.
Preventing information leakage (with Dan Li, Matthew Ma, and Ryan Riordan) Abstract
Traders devote significant resources to producing private information. The value of such informational is eroded when it is leaked. We study the use of multiple brokers by institutions to help mitigate information leakage. We document that trades using multiple brokers better predict future returns, consistent with information possessed by investors driving the decision to use multiple brokers. We find that trades using multiple brokers have lower price impacts and implementation shortfalls, higher long-term profitability, and fewer follower trades than similar single broker trades. The results suggest that traders use multiple brokers to successfully reduce information leakage.
Stock market liquidity and loan contracting (with Phong Ngo and Ying Xia) Abstract
We examine how liquidity in the equity market affects bank lending costs. An exogenous decrease in liquidity during the SEC Tick Size Pilot Program raises corporate bank borrowing costs; an effect that reverses when the program ends. We find similar results in a broad panel of firms using both retail and institutional measures of liquidity. We identify three non-mutually exclusive channels driving this effect. Liquidity increases the price informativeness, enhances external monitoring by blockholders, and weakens the holdup problem in relationship banking. Finally, consistent with our channels we show that firms obtain larger loans with fewer covenant and collateral requirements.
Competition and exchange data fees (with James Brugler and Dominik Rosch) Abstract
Exchanges are monopolist suppliers of their own order book data. We examine three events where exchanges begin charging a fee for order book data for the first time and test whether or not these fees affect their market share in a difference-in-differences setting. We find that the introduction of fees leads to a fall of market share of around 5-8 percent. Examining average trading costs, price impact and dealer revenue per trade around the events indicates that order routing decisions of informed traders are relatively more sensitive to order book data fees than other trader categories.
Does financial innovation lead to real innovation? Evidence from financial derivatives (with Lora Dimitrova and Sapnoti Eswar) Abstract
We investigate whether financial innovation, specifically the introduction of derivative products, spurs firms’ real innovation, measured with patent based metrics. Consistent with financial innovation being an important contribution to real innovation, we find that the use of financial derivatives causes firm patent production to increase. The main mechanism behind the relationship is improved risk management. Derivatives usage decreases cash flow volatility, decreasing the need for external financing, and allowing firms to expand their innovative projects.
Does shareholder litigation risk cause public firms to delist? Evidence from securities class action lawsuits (with Nhan Le, Duc Duy Nguyen, and Vathunyoo Sila) Abstract
This paper examines whether shareholder litigation contributes to the decline in the number of U.S. stock market listings. We find that higher litigation risk induces firms to delist. We establish causality using two exogenous shocks to ex-ante litigation risk, including federal judge ideology and an influential judicial precedent. We find that the effect is at least partially driven by indirect costs of litigation and that being private can significantly reduce the threat of litigation. The results suggest that mitigating excessive litigation costs for public firms is crucial to ensure the continued vibrancy of the U.S. stock market.
The effect of female leadership on contracting from capitol hill to main street (with Nataliya Gerasimova and Maximilian Rohrer) Abstract
This paper provides novel evidence that female politicians increase the proportion of US government procurement contracts allocated to women-owned firms. The identification strategy uses close elections for the US House of Representatives. The effect concentrates in local contractors and persists after the female’s politician departure. The more gender-balanced representation in government contracting does not seem to be associated with economic costs, as the firm characteristics of the average contractor and contract performances are unchanged. By analyzing congressional requests from legislators to federal agencies, we show that female politicians affect procurement contract allocation through individual oversight.
The heterogeneous effects of passive investing on asset markets (with Davidson Heath and Da Huang) Abstract
This paper shows that passive funds systematically underweight or omit illiquid index assets. As a result, ETF trading activity consumes liquidity and reduces market quality for liquid assets, but has no effect on illiquid assets. Focusing on the unconditional average effect of passive investing and ignoring the passive funds' index deviations underestimates the local treatment effect by up to 58%. Overall, the effects of passive investing on asset markets depend on how intermediaries replicate their target index.
How do extreme price movements end? (with Konstantin Sokolov and Jiang Zhang) Abstract
We test competing theories on liquidity dynamics during extreme price movements (EPMs). Our findings indicate that market makers strategically allow for price pressures and earn compensation from pricing errors. As a result, liquidity provision intensifies towards the end of an average EPM. This goes counter to a widespread concern that market making constraints cause the deterioration of liquidity as EPMs develop. Finally, we demonstrate that limit order book dynamics during EPMs is in line with a socially beneficial equilibrium.
The broken bond market (with Yesha Yadav) Abstract
Valued at $11.2 trillion – equivalent in size to half the U.S. economy – the corporate bond market is opaque, illiquid and inefficient. This Article argues that the bond market – premised on contract – rests on a fundamentally flawed regulatory design that delivers neither investor protection nor market quality. It makes three contributions. First, it shows that bondholders face a conflict between securing creditor control using a tailorable contact – and the tradability of their bond claim. By tailoring a contract to match the riskiness of an issuer, bondholders end up holding a less standard claim that becomes harder and costlier to trade. Secondly, the Article develops the implications of this conflict for investor protection. Bondholders assume transaction costs that do not exist in equity markets. Activism is more difficult as investors cannot use the threat of exit cheaply to pressure managers. Monitoring costs are high as prices lack a credible surveillance function. Seen through the lens of this conflict, this Article refines the traditional notion of bondholders as being passive actors. Rather, the impossibility of achieving both control and tradability limits bondholders in their ability to push back against managerial and shareholder agency costs. In concluding, this Article sets out a three-part solution designed to create choice, control and liquidity. It proposes: (i) standardization through the creation of tiers of form contracts that can enhance liquidity while offering tailorability in the choice of model contract; (ii) a stronger role for trading platforms in monitoring and enforcing contract terms; and (iii) retaining features of the status quo as part of the new market to accommodate those that need full tailorabilty even at the cost to tradability. This solution seeks to repair the broken bond market and assure that bondholders enjoy both investor protection and market quality as a part of their claim.