Hans R. Stoll

Optimal dealer pricing under transactions and return uncertainty

Abstract The paper examines the optimal behavior of a single dealer who is faced with a stochastic demand to trade (modeled by a continuous time Poisson jump process) and facing return risk on his stock and on the rest of his portfolio (modeled by diffusion processes). Using stochastic dynamic programming, we derive the optimal bid and ask prices that maximize the dealers expected utility of terminal wealth as a function of the state in which he finds himself. The relationship of the bid and ask prices to inventory of the dealer, instantaneous variance of return, stochastic arrival of transactions and other variables is examined.

Dealer versus auction markets: A paired comparison of execution costs on NASDAQ and the NYSE

Execution costs for a sample of Nasdaq stocks significantly exceed those for a matched sample of NYSE stocks. Execution costs are measured by the quoted spread, the effective spread (which accounts for trades inside the quotes), the realized spread (which measures revenues of suppliers of immediacy), the Roll (1984) implied spread, and a measure of post-trade variability. By these measures the Nasdaq execution cost is twice the NYSE cost. The difference is not due to differences in the stocks, for we match on stock characteristics. Nor is it due to the presence of informed traders, for we find that Nasdaq dealers lose a smaller fraction of the quoted spread than do NYSE suppliers of immediacy. We rule out differences in the frequency of even eighth quotes. The increase in affirmative obligation on dealers and the rise in institutional trading are eliminated as possible sources of the differential. Partial explanations are provided by the fact that Nasdaq dealers do not charge commissions to institutions and that limit orders cannot compete with dealers in Nasdaq. We conclude that the primary explanation is the internalization and preferencing of order flow on Nasdaq that limit the incentive to narrow spreads. Execution costs are large because there has been little incentive to reduce them.

The Dynamics of Stock Index and Stock Index Futures Returns

In rational, efficiently functioning markets, the returns on stock index and stock index futures contracts should be perfectly, contemporaneously correlated. This study investigates the time series properties of 5-minute, intraday returns of stock index and stock index futures contracts, and finds that SP however, the effect is not completely unidirectional, with lagged stock index returns having a mild positive predictive impact on futures returns.

Energy Shocks and Financial Markets

This study analyzes the information transmission mechanism linking oil futures with stock prices, where we examine the lead and lag cross-correlations of returns in one market with the others. We investigate the dynamic interactions between oil futures prices traded on the New York Mercantile Exchange (NYMEX) and U.S. stock prices, which allows us to examine the effects of energy shocks on financial markets. In particular, we examine the extent to which these markets are contemporaneously correlated, with particular attention paid to the association of oil price indexes with the SP 12 major industry stock price indices and 3 individual oil company stock price series. We also examine the extent to which price changes or returns in one market dynamically lead returns in the others and whether volatility spillover effects exist across these markets. Using VAR model estimates for various time series of returns we find that petroleum industry stock index and our three oil company stocks are the only series where we can reject the null hypothesis that oil futures do not lead Treasury Bill rates and stock returns, while we can reject the hypothesis that oil futures lag these other two series. Finally, the return volatility evidence for oil futures leading individual oil company stocks is much weaker than is the evidence for returns themselves.

Transaction costs and the small firm effect

Abstract Recent empirical work by Banz (1981) and Reinganum (1981) documents abnormally large risk-adjusted returns for small firms listed on the NYSE and the AMEX. The strength and persistence with which the returns appear lead both authors to conclude the single-period, two-parameter capital asset pricing model is misspecified. This study (1) confirms that total market value of common stock equity varies inversely with risk-adjusted returns, (2) demonstrates that price per share does also, and (3) finds that transaction costs at least partially account for the abnormality.

Presidential Address: Friction

The sources of trading friction are studied, and simple, robust empirical measures of friction are provided. Seven distinct measures of trading friction are computed from transactions data for 1,706 NYSE/AMSE stocks and 2,184 Nasdaq stocks. The measures provide insights into the magnitude of trading costs, the importance of informational versus real frictions, and the role of market structure. The degree to which the various measures are associated with each other and with trading characteristics of stocks is examined. Copyright The American Finance Association 2000.

Small Business and the New Issues Market for Equities

A great deal of interest has been expressed by economists and policy-makers concerning the adequacy of the financing of small and, especially, new firms. This paper presents an empirical study of the adequacy of one particular source of funds—outside equity.

Electronic Trading in Stock Markets

Modern trading technology clashes with the traditional organization of a stock exchange, where transactions were consummated via face-to-face negotiation. The modern trading facility is no longer a place. Rather, it is a computer system over which transactions are entered, routed, executed and cleared electronically with little or no human intervention. In this article, I examine how electronic trading has altered stock markets. I begin with an overview of how the stock trading process works and then address a number of questions. How have the jobs of traditional stock market dealers on the NYSE and on Nasdaq been affected by electronic trading? How do electronic communications networks differ from traditional markets? How has electronic trading affected bid-ask spreads and commission costs? What subtle issues arise in electronic trading when dealer and customer interests diverge? Will computer programs replace human judgment? What is the effect of electronic trading on the number and types of securities markets? What is the role of regulation in electronic markets?

Tick Size, Bid-Ask Spreads, and Market Structure

We propose a link between market structure and the resulting market characteristics—tick size, bid-ask spreads, quote clustering, and market depth. We analyze transactions data of stocks traded on the London Stock Exchange, a dealer market. We conclude that market charateristics are endogenous to the market structure. The London dealer market does not have a mandated tick size, and it exhibits higher spreads, higher quote clusterings, and higher market depth than the NYSE auction market. Clustering of trade prices is similar in London and New York.

Parallel Trading by Institutional Investors

A belief frequently expressed by observers of the stock market is that groups of institutions tend to trade in the same way at the same time. Two expressions of this belief follow:Frequently reference is made to the ‘impact’ of institutional investors on the stock market. Apparently it is worrisome to the observers of the markets to find that we tend to buy and sell somewhat in unison.