National Bureau of Economic Research Working PapersThe Latest NBER Working Papers
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Welfare and Optimal Trading Frequency in Dynamic Double Auctions -- by Songzi Du, Haoxiang ZhuThis paper studies the welfare consequence of increasing trading speed in financial markets. We build and solve a dynamic trading model, in which traders receive private information of asset value over time and trade strategically with demand schedules in a sequence of double auctions. A stationary linear equilibrium and its efficiency properties are characterized explicitly in closed form. Slow trading (few double auctions per unit of time) serves as a commitment device that induces aggressive demand schedules, but fast trading allows more immediate reaction to new information. If all traders have the same speed, the socially optimal trading frequency tends to be low for scheduled arrivals of information but high for stochastic arrivals of information. If traders have heterogeneous trading speeds, fast traders prefer the highest feasible trading frequency, whereas slow traders tend to prefer a strictly lower frequency.
http://papers.nber.org/papers/w20588#fromrss
http://papers.nber.org/papers/w20588#fromrssValuing Thinly-Traded Assets -- by Francis LongstaffWe model illiquidity as a restriction on the stopping rules investors can follow in selling assets, and apply this framework to the valuation of thinly-traded investments. We find that discounts for illiquidity can be surprisingly large, approaching 30 to 50 percent in some cases. Immediacy plays a unique role and is valued much more than ongoing liquidity. We show that investors in illiquid enterprises have strong incentives to increase dividends and other cash payouts, thereby introducing potential agency conflicts. We also find that illiquidity and volatility are fundamentally entangled in their effects on asset prices. This aspect may help explain why some assets are viewed as inherently more liquid than others and why liquidity concerns are heightened during financial crises.
http://papers.nber.org/papers/w20589#fromrss
http://papers.nber.org/papers/w20589#fromrssUnderstanding Defensive Equity -- by Robert Novy-MarxHigh volatility and high beta stocks tilt strongly to small, unprofitable, and growth firms. These tilts explain the poor absolute performance of the most aggressive stocks. In conjunction with the well documented inability of the Fama and French three-factor model to price small growth stocks, especially unprofitable small growth stocks, these tilts also drive the abnormal performance of defensive equity (i.e., low volatility and/or low beta strategies). While defensive strategy performance is explained by controlling for size, profitability, and relative valuations, the converse is false--the performance of value and profitability strategies cannot by explained using defensive equity performance.
http://papers.nber.org/papers/w20591#fromrss
http://papers.nber.org/papers/w20591#fromrss. . . and the Cross-Section of Expected Returns -- by Campbell R. Harvey, Yan Liu, Heqing ZhuHundreds of papers and hundreds of factors attempt to explain the cross-section of expected returns. Given this extensive data mining, it does not make any economic or statistical sense to use the usual significance criteria for a newly discovered factor, e.g., a t-ratio greater than 2.0. However, what hurdle should be used for current research? Our paper introduces a multiple testing framework and provides a time series of historical significance cutoffs from the first empirical tests in 1967 to today. Our new method allows for correlation among the tests as well as missing data. We also project forward 20 years assuming the rate of factor production remains similar to the experience of the last few years. The estimation of our model suggests that a newly discovered factor needs to clear a much higher hurdle, with a t-ratio greater than 3.0. Echoing a recent disturbing conclusion in the medical literature, we argue that most claimed research findings in financial economics are likely false.
http://papers.nber.org/papers/w20592#fromrss
http://papers.nber.org/papers/w20592#fromrssCompeting for Order Flow in OTC Markets -- by Benjamin Lester, Guillaume Rocheteau, Pierre-Olivier WeillWe develop a model of a two-sided asset market in which trades are intermediated by dealers and are bilateral. Dealers compete to attract order flow by posting the terms at which they execute trades-- which can include prices, quantities, and execution speed--and investors direct their orders toward dealers that offer the most attractive terms. We characterize the equilibrium in a general setting, and illustrate how the model can account for several important trading patterns in over-the-counter markets which do not emerge from existing models. We then study two special cases which allow us to highlight the differences between these existing models, which assume investors engage in random search for dealers and then use ex post bargaining to determine prices, and our model, which utilizes the concept of competitive search in which dealers post terms of trade. Finally, we calibrate our model, illustrate that it generates reasonable quantitative outcomes, and use it to study how trading frictions affect the per-unit trading costs that investors pay in equilibrium.
http://papers.nber.org/papers/w20608#fromrss
http://papers.nber.org/papers/w20608#fromrss