Bidisha Chakrabarty

A Competing Risk Analysis of Executions and Cancellations in a Limit Order Market

The competing risks technique is applied to the analysis of times to execution and cancellation of limit orders submitted on an electronic trading platform. Time-to-execution is found to be more sensitive to the limit price variation than time-to-cancellation, even though it is less sensitive to the limit order size. More importantly, investors who aim to reduce the expected time-to-execution for their limit orders without inducing any significant increase in the risk of subsequent cancellation should submit their orders when the market depth is smaller on the side of their orders or when the market depth is greater on the opposite side of their orders. We also provide a new diagnostic plots method for evaluating the goodness-of-fit of different competing risks models.

Evaluating Trade Classification Algorithms: Bulk Volume Classification versus the Tick Rule and the Lee-Ready Algorithm

We compare bulk-volume classification (BVC) proposed by Easley, Lopez de Prado, and O’Hara (2012b) to the traditional tick rule (TR) for a sample of equity trades executed on NASDAQ’s INET platform. Applying BVC leads to substantial time savings when a researcher uses pre-compressed data like Bloomberg and to smaller time savings when a researcher uses TAQ. Notably, this efficiency comes at a significant loss of accuracy. Specifically, misclassification increases by 7.4 to 16.3 percentage points (or 46% to 291%) when switching from TR to BVC. Additionally, TR produces more accurate estimates of order imbalances and of order flow toxicity (VPIN).

The Performance of Short-term Institutional Trades

Using a proprietary database of institutional money manager and pension fund transactions, we find wide dispersion in trade holding periods. For example, all of the institutional funds execute roundtrip trades lasting over a year, and 96% of them also execute trades lasting less than one month. In aggregate over seven percent of volume occurs in trades that are held for less than one month, although short-duration trades have negative returns on average. Our empirical results show mixed support for the idea that institutions make trade holding period decisions based on portfolio optimization, some evidence of persistent information or trading skill in short-duration trades, and no evidence that short-duration institutional trades are driven by the disposition effect or overconfidence. Our results are consistent with the agency problem that arises when clients cannot distinguish when a manager is “actively doing nothing” versus “simply doing nothing.”

Attention Effects in a High-Frequency World

How does limited attention affect stock prices following earnings announcements in today’s computer-driven financial markets? We examine the effects of limited attention using a dataset that separately identifies trades made by high-frequency traders (HFTs, or computers) versus non-high-frequency traders (human decision-makers). Using six attention proxies, we find pricing inefficiencies lower by 64% to 100% when HFTs trade following low-attention earnings announcements. An event study of an exogenous shock to algorithmic trading suggests that computerized trading causally reduces low-attention effects. Price efficiency improvements are more closely tied to HFT liquidity demand than supply, consistent with HFTs improving efficiency by processing and aggressively trading on the information in low-attention announcements.

Shackled High Speed Traders? Latency Reduction and Short Sale Bans

We examine the market quality effects of technology upgrades juxtaposed with short-sale bans. Between 2011 and 2013, the Spanish Stock Exchange introduced a smart trading platform (SIBE-Smart) and colocation to facilitate high-speed trading, and they also imposed two short-sale bans. We find that the SIBE-Smart introduction, which occurs between the two short-sale bans, leads to reduced market quality. The introduction of colocation, which occurs during the second short-sale ban, improves market liquidity although it does not attract additional high-speed trading. Our results highlight how the effects of latency-reducing infrastructure improvements depend on, and differ across, different regulatory regimes.

Management Risk Incentives and the Readability of Corporate Disclosures

We show that managers with greater options vega undertake riskier firm policies and issue less readable corporate disclosures (Form 10-Ks). Ceteris paribus, a manager in the top quartile of vega files a Form 10-K that is 18.56% percent more voluminous than that of a bottom quartile vega manager. The effect of vega on disclosure obfuscation remains after controlling for firm risk, operating complexities and accounting choices, but is moderated by higher institutional ownership and greater shareholder rights, suggesting strategic disclosure obfuscation. These findings uncover a new (and unintended) link between incentive compatible compensation contracts and disclosure complexity.

A New Approach to Estimating the Relation between Audit Fees and Financial Misconduct

Corporate fraud imposes a large social cost, estimated at 22 cents per dollar invested in the fraud firm, yet misreporting firms have a low likelihood of being detected (Dyck, Morse and Zingales, 2013). Auditors, who are expected to be at the forefront of fraud detection, lag behind other stakeholders in uncovering misstatements. We investigate auditors’ poor record in detecting fraud using a new measure of financial statement manipulation that, unlike previous measures, is an ex-ante measure of misstatement and is not commingled with a firm’s business and economic risks. We posit that auditors balance their client retention motive with reputational costs when auditing a firm. Since investors can infer audit effort from the publicly disclosed audit fee, the reputational impact of misstatements may be contingent on the perceived effort. Thus, despite having reputational incentives to prevent misstatements, the expected rents to the auditor of retaining a potentially misstating client may outweigh the reputational cost when the audit fee is low. Consistent with the retention effect, we find a negative relation between the likelihood of material misstatement and audit fees. This effect is economically significant as a one standard deviation increase in misstatement risk associates with an 8.5% fee reduction. In additional testing, we find no evidence that auditors signal investors to the reduced financial statement quality through alternate channels. Furthermore, although a strong audit committee is related to fewer misstatements, it does not mitigate the negative relation between material misstatements and audit fees.Research on the association between abnormal audit fees (measuring audit effort) and financial misconduct has produced mixed results. The use of actual misstatements in this research creates small-sample inferences, introduces systematic selection bias, and reduces the scope of sample coverage. In this study we use a metric based on Benford’s Law to analyze the impact of abnormal audit fees on the likelihood of misconduct. This measure is parsimonious, avoids selection bias, and can be computed for a large sample of public firms. Consistent with theory, we find that greater audit effort reduces the likelihood of misconduct and auditor resignations are more likely for clients with higher misconduct likelihood. Our findings are not driven by audit firm size, client size, the governance structure of the client, or economic bonding explanations. The effect is not subsumed when controlling for alternative misconduct measurement metrics and is robust across multiple tests to address endogeneity.

Do High Frequency Traders Bring Fundamental Information into Prices

Prompted by concerns that high frequency traders (HFTs) reap unfair advantages over other traders by using faster trading technologies, regulators are contemplating measures to slow down equity markets. Currently, HFTs account for a significant fraction of the total market volume. Although regulatory proposals are aimed at curbing HFTs’ ultra-low-latency activities, research suggests that HFTs play various other roles in markets, including liquidity provision as voluntary market makers. However, little is known about their role in incorporating firm-specific fundamental information into prices. Employing a novel dataset that identifies trades by HFTs and non-HFTs, we investigate whether HFTs facilitate incorporation of longer-term fundamental information revealed via earnings announcements. We find that earnings response coefficients are larger and abnormal price impact of trades is lower when HFTs trade more following earnings announcements, suggesting that HFTs facilitate efficient assimilation of earnings news. HFTs also enhance the forecasting capabilities of financial analysts; specifically forecast dispersion is lower and forecast revision speed is faster for announcements with greater HFT presence. Furthermore, HFT participation increases return synchronicity around earnings announcements when multiple firms in the same industry announce earnings on the same day, suggesting that HFTs help incorporate relevant industry information. This effect arises from HFTs’ liquidity supplying function. We address the endogenous preference of HFTs for large and liquid stocks by including multiple controls for size and liquidity, implementing abnormal or change specification for the price impact tests, and performing pre-treatment placebo tests for all of our analyses.

Audit Fees and Misstatements: A Fresh Look from an Ex-Ante Perspective

Corporate fraud imposes a large social cost, estimated at 22 cents per dollar invested in the fraud firm, yet misreporting firms have a low likelihood of being detected (Dyck, Morse and Zingales, 2013). Auditors, who are expected to be at the forefront of fraud detection, lag behind other stakeholders in uncovering misstatements. We investigate auditors’ poor record in detecting fraud using a new measure of financial statement manipulation that, unlike previous measures, is an ex-ante measure of misstatement and is not commingled with a firm’s business and economic risks. We posit that auditors balance their client retention motive with reputational costs when auditing a firm. Since investors can infer audit effort from the publicly disclosed audit fee, the reputational impact of misstatements may be contingent on the perceived effort. Thus, despite having reputational incentives to prevent misstatements, the expected rents to the auditor of retaining a potentially misstating client may outweigh the reputational cost when the audit fee is low. Consistent with the retention effect, we find a negative relation between the likelihood of material misstatement and audit fees. This effect is economically significant as a one standard deviation increase in misstatement risk associates with an 8.5% fee reduction. In additional testing, we find no evidence that auditors signal investors to the reduced financial statement quality through alternate channels. Furthermore, although a strong audit committee is related to fewer misstatements, it does not mitigate the negative relation between material misstatements and audit fees.Research on the association between abnormal audit fees (measuring audit effort) and financial misconduct has produced mixed results. The use of actual misstatements in this research creates small-sample inferences, introduces systematic selection bias, and reduces the scope of sample coverage. In this study we use a metric based on Benford’s Law to analyze the impact of abnormal audit fees on the likelihood of misconduct. This measure is parsimonious, avoids selection bias, and can be computed for a large sample of public firms. Consistent with theory, we find that greater audit effort reduces the likelihood of misconduct and auditor resignations are more likely for clients with higher misconduct likelihood. Our findings are not driven by audit firm size, client size, the governance structure of the client, or economic bonding explanations. The effect is not subsumed when controlling for alternative misconduct measurement metrics and is robust across multiple tests to address endogeneity.

Client Retention or Reputation? An Analysis of Audit Fees and Material Misstatements

Corporate fraud imposes a large social cost, estimated at 22 cents per dollar invested in the fraud firm, yet misreporting firms have a low likelihood of being detected (Dyck, Morse and Zingales, 2013). Auditors, who are expected to be at the forefront of fraud detection, lag behind other stakeholders in uncovering misstatements. We investigate auditors’ poor record in detecting fraud using a new measure of financial statement manipulation that, unlike previous measures, is an ex-ante measure of misstatement and is not commingled with a firm’s business and economic risks. We posit that auditors balance their client retention motive with reputational costs when auditing a firm. Since investors can infer audit effort from the publicly disclosed audit fee, the reputational impact of misstatements may be contingent on the perceived effort. Thus, despite having reputational incentives to prevent misstatements, the expected rents to the auditor of retaining a potentially misstating client may outweigh the reputational cost when the audit fee is low. Consistent with the retention effect, we find a negative relation between the likelihood of material misstatement and audit fees. This effect is economically significant as a one standard deviation increase in misstatement risk associates with an 8.5% fee reduction. In additional testing, we find no evidence that auditors signal investors to the reduced financial statement quality through alternate channels. Furthermore, although a strong audit committee is related to fewer misstatements, it does not mitigate the negative relation between material misstatements and audit fees.Research on the association between abnormal audit fees (measuring audit effort) and financial misconduct has produced mixed results. The use of actual misstatements in this research creates small-sample inferences, introduces systematic selection bias, and reduces the scope of sample coverage. In this study we use a metric based on Benford’s Law to analyze the impact of abnormal audit fees on the likelihood of misconduct. This measure is parsimonious, avoids selection bias, and can be computed for a large sample of public firms. Consistent with theory, we find that greater audit effort reduces the likelihood of misconduct and auditor resignations are more likely for clients with higher misconduct likelihood. Our findings are not driven by audit firm size, client size, the governance structure of the client, or economic bonding explanations. The effect is not subsumed when controlling for alternative misconduct measurement metrics and is robust across multiple tests to address endogeneity.