Albert J. Menkveld

High frequency trading and the new-market makers

This paper characterizes the trading strategy of a large high-frequency trader (HFT). The HFT incurs a loss on its inventory but earns a profit on the bid-ask spread. Sharpe ratio calculations show that performance is very sensitive to cost of capital assumptions. The HFT employs a cross-market strategy as half of its trades materialize on a large incumbent market and the other half on a small, high-growth entrant market. Trade participation rates are 8.1% and 64.4%, respectively. In both markets, about four out of five of its trades are passive, i.e., its price quote was consumed by others.

Middlemen in Limit Order Markets

We model high-frequency traders in electronic markets. We ask how the presence of such middlemen may affect welfare. We find that middlemen process public information faster than the average investor. As such, they can play a positive or a negative role. On the positive side, when they enter a market they can raise welfare by solving a pre-existing adverse selection problem. In that case their entry is accompanied by a rise in trade and a fall in bid-ask spreads, and they can raise welfare by up to 30% of the gap between its equilibrium level and its first-best level. On the negative side, they can create or exacerbate an adverse- selection problem, in which case spreads rise and trade declines. Our evidence on this score is mixed. On the one hand, middlemen’s participation lowers spreads but, on the other, it also lowers trade.

The Informativeness of Domestic and Foreign Investors' Stock Trades: Evidence from the Perfectly Segmented Chinese Market

This paper uses the perfect market segmentation setting in Chinas stock market to compare the information content of the stock trades of domestic and foreign investors. We study 76 firms that issue both A-shares (for domestic investors) and B-shares (for foreign investors) and compare the price discovery role of the two segmented markets in China. Before Feb 19, 2001, the A-share market led the B-share market in price discovery, as the signed volume and quote revision of the A-share market had strong predictive ability for B-share quote returns, but not vice versa. After Feb 19, 2001, because some domestic investors were allowed to invest in the B-share market, we find evidence for a reverse causality from the B-share to the A-share market. Nevertheless, the Hasbrouck (1995) information share analysis reveals that A-shares continue to dominate the price discovery process.

Intraday Analysis of Market Integration: Dutch Blue Chips Traded in Amsterdam and New York

Market integration is studied for Dutch stocks cross-listed at the NYSE. Trading starts in Amsterdam and ends in New York with a one-hour overlap. Both markets are not perfectly integrated in that they can be viewed as one market with the well-documented U-shape in volatility, volume and spread. Increased values for the hour of overlap suggest informed trading. Zooming in on this hour, markets are integrated in that price discovery on both sides of the Atlantic reflects the same underlying, new information. Not consistent across all stocks is the origin of this information, Amsterdam, New York or both.

Modelling Round-the-Clock Price Discovery for Cross-Listed Stocks Using State Space Methods

U.S. trading in non-U.S. stocks has grown dramatically. Around the clock, these stocks trade in the home market, in the U.S. market, and, potentially, in both markets simultaneously. We develop a general methodology based on a state space model to study 24-hour price discovery in a multiple-markets setting. As opposed to the standard variance ratio approach, this model deals naturally with (1) simultaneous quotes in an overlap, (2) missing observations in a nonoverlap, (3) noise due to transitory microstructure effects, and (4) contemporaneous correlation in returns due to market-wide factors. We apply our model to Dutch stocks, cross-listed in the United States. Our findings suggest a minor role for the New York Stock Exchange in price discovery for Dutch shares, in spite of its nontrivial and growing market share.

Need for Speed? Exchange Latency and Liquidity

A faster exchange does not necessarily improve liquidity. On the one hand, speed enables a high-frequency market maker (HFM) to update quotes faster on incoming news. This reduces payoff risk and thus lowers the competitive bid-ask spread. On the other hand, HFM price quotes are more likely to meet speculative high-frequency bandits, and thus are less likely to meet liquidity traders. This raises the spread. The net effect of exchange speed depends on a securitys news-to-liquidity-trader ratio.

Customer Order Flow, Intermediaries, and Discovery of the Equilibrium Risk-free Rate

Macro announcements change the equilibrium risk-free rate. We find that Treasury prices reflect part of the impact instantaneously, but intermediaries rely on their customer order flow after the announcement to discover the full impact. This customer flow informativeness is strongest when analyst macro forecasts are most dispersed. The result holds for 30-year Treasury futures trading in both electronic and open-outcry markets. We further show that intermediaries benefit from privately recognizing informed customer flow, as their own-account trading profitability correlates with customer order access.

High‐Frequency Traders and Market Structure

The arrival of high-frequency traders (HFTs) coincided with the entry of new markets and, subsequently, strong fragmentation of the order flow. These trends might be related as new markets serve HFTs who seek low fees and high speed. New markets only thrive on competitive price quotes that well-connected HFTs can deliver as they can offload any nonzero position in any market they are connected to. HFTs may benefit or hurt market quality through adverse selection on price quotes, a technology arms race, or high-risk trading strategies.

A Pricing Model for American Options with Gaussian Interest Rates

In this paper we introduce a new methodology to price American put options under stochastic interest rates. We derive an analytic approximation that can be evaluated very fast and is fairly accurate. The method uses the so-called forward risk adjusted measure to derive analytic prices. We show that for American puts the correlation between the stock price and the interest rate has different influences on European option values and early exercise premiums.

Asset Price Dynamics with Limited Attention

We study how limited attention and inefficient risk sharing relate to stock prices deviating from a (random walk) efficient price. The Duffie (2010) inattention model is extended to include multiple investor types with varying attention levels. The model’s predictions are tested with New York Stock Exchange data. Eight percent of a stock’s daily idiosyncratic return variance and 25% of its monthly idiosyncratic variance are due to transitory price changes. The trading variables explain 32% of these changes. The model further explains contemporaneous, lead, and lag correlations among returns and the trading by institutions, individuals, and market makers.