Robert A. Schwartz

Friction in the trading process and the estimation of systematic risk

Abstract This paper considers how estimates of the market model beta parameter can be biased by friction in the trading process (information, decision, and transaction costs) that (a) leads to a distinction between observed and ‘true’ returns; (b) causes observed returns to be generated asynchronously for a set of interdependent securities; and (c) thereby introduces serial cross-correlation into security returns. Several propositions are derived from which consistent estimators of beta are obtained, and the effect of differencing interval length on beta estimates is specified. The formulation is contrasted with the related analyses of Scholes-Williams (1977) and Dimson (1979).

An analysis of the economic justification for consolidation in a secondary security market

Abstract This paper considers whether all trading in a listed security should be required to go through an exchange. To this end, the incentives for a brokerage firm to offer in-house execution services are discussed, and an analytical framework is developed which shows that, under idealized conditions, fragmentation of the market through in-house execution services would not result in any overall deterioration of market performance characteristics. However, when some of the idealized conditions are relaxed, the market fragmentation arising from in-house execution causes the gains to some customers to be more than overcome by the losses to others. The analysis, which also takes account of the desirability of enforcing reasonable trading priority rules (such as priority by price and time) across all traders, yields several public policy implications. For some unlikely scenarios, it would be possible, through appropriate commission sharing and a perfectly operating intermarket trading system, for optimal overall market performance to be consistent with the market fragmentation inherent in in-house execution services. However, for most realistic scenarios, fragmentation would cause a deterioration in the quality of the market. Thus it seems desirable to require that all trading go through a central exchange with a consolidated limit order book.

A simulation model of stock exchange trading

A simulation model of stock exchange trading is used to test the impact of various stabilization policies on a stocks market per formance characteristics (price volatility, the size of its bid-ask spread, and autocorrelation patterns in the securitys returns). Market participants include large and small traders, a pure stabilizer, and a speculating stabilizer. The market architecture includes the arrival of market and limit orders the maintenance of a limit order book, and the handling of trade execution. Each type of stabilizer improves the operating characteristics of the market, with the speculating stabilizer having a bigger impact and realizing more profits than the pure stabilizer. Using the mechanism of simulation to eliminate other sources of the stabilizers profit, we find that stabilization per se is an un profitable activity. We then suggest additional ways in which the simulation model could be developed and further uses for it.

Adjusting for the intervalling effect bias in beta : A Test using Paris Bourse Data

Abstract This paper uses a sample of daily returns data from the Paris Bourse to test the predictions of and adjustment procedures implied by the Cohen-Hawawini-Maier-Schwartz-Whitcomb (1983a,b) model of the intervalling effect bias in OLS beta estimates. CHMSW show that the bias diminishes asymptotically to zero as the differencing interval increases and that the sign of the bias depends on a stocks relative value of shares outstanding. We employ the three-pass regression procedure of CHMSW (1983b), but we test a broader set of second pass functional forms and use the Box-Cox (1964) transformation model to verify our chosen form. The CHMSW adjustment procedures are compared with that of Scholes-Williams (1977), and the latter is shown to contain a significant intervalling effect bias.

The impact of designated market makers on security prices

Abstract This paper is divided into two distinct parts. Part I, Empirical Evidence, tests a previously formulated variance, thinness relationship for security returns. First quarter 1972 daily returns variance is regressed on market value of shares, share price, trading activity, sales variance, and institutional holdings for 178 firms selected by stratified random sampling from AMEX and NYSE (specialist exchanges), and from Tokyo and Rio de Janeiro (non-specialist exchanges). The principal finding is that returns variance and market value are inversely related on non-specialist exchanges, but not on specialist exchanges; this difference is attributed to specialists impact. Part II, Policy Proposals, discusses the manner in which designated market makers may be effectively incorporated into a continuous auction exchange. Issues discussed include: desirability of price stabilization, transfers implicit in the existing U.S. specialist system, consolidation and public availability of the limit order book, number of designated market makers for a security, competitive bidding, and compensation for performing the price stabilization function. Stabilization is modeled as an external economy, and specific policy proposals for internalizing it are advanced.

Dynamic Price Discovery

This article analyzes the dynamic process of price discovery in a competitive securities market where investors are equally informed about the fundamental determinants of an assets end-of-period value but, because they do not know each others wealth positions, do not know the equilibrium price of shares at the start of a current trading session. Because a large number of participants is assumed, issues concerning market impact and market manipulation are avoided. As trading progresses, participants update their expectations of an assets equilibrium value. As they do so, price can either converge to a new level or, following a run, revert back to a previous level. This implies that, in clusters of adjacent prices, price changes are more apt to be predominantly of like sign (positive or negative) than would be the case under random walk with a bid-ask spread. Moreover, reversals, when they do occur, should be larger than continuations. An examination of 1988 transactions data for the 30 Dow Jones Industrial stocks shows that this is indeed the case. With the effect of the bid-ask spread removed, first-order autocorrelation coefficients are found to be positive.

Combining quote-driven and order-driven trading systems in next-generation stock markets: an experimental investigation

We use computer-based simulations of a stock market as a background environment for experimental tests of the integration of an order-driven trading system into a dealer/quote-driven market. Experimental subjects traded using a traditional dealer quote screen (such as Nasdaq or SEAQ), to which a limit order facility was added. Subjects trading decisions revealed that: (1) when available, the limit order facility attracted investor orders that would have otherwise gone to dealers, and reduced trading costs; (2) the relative use of market orders and limit orders was affected by the bid-ask spread, wider spreads led subjects to substitute limit orders for market orders; (3) limit order use was reduced when the dealers were provided with an informational advantage; (4) while the introduction of a limit order facility did not have an adverse effect on dealer profit margins, dealers activities as a percentage of total volume declined. Overall, the simulation environment provides insights into the effects of market design changes, and guidance on market structure issues, such as how best to incorporate a limit order facility into a dealer market.

A proposal to stabilize stock prices: Reply to comment

arrell and Seguin (JS) agree that there are questions concerning short-term price volatility and the adequacy of market-maker capital, but doubt the advisability of involving listed companies in market making in the manner I have suggested. At issue is whether my proposal would indeed stabilize prices. I believe it would. I believe that all price changes are not straightforwarld reflections of news and that the search for new equilibrium following informational change is a noisy process. Alternatively stated, in non-frictionless markets, all price changes do not take place along long-ntn market demand curves, and the relative inelasticity and instability of short-run demand can cause exaggerated short-run price swings. For this reason, additional liquidity must be supplied to a marketplace. [Given this need, I stress the advantages of allowing corporations to commit capital to market making if they so choose: 1) their self-supply of capital could be substantial, 2) they would realize an important benefit that would not accrue to a third-party market maker (a lower cost of equity capital), and 3) their involvement could obviate a further concentration of power in the securities industry. ’There is a problem, however extending this freedom to corporations might also enable them to mimipidate share prices. My solution is to establish a fully articulated, transparent procedure. I propose that each firm trade only prescribed amounts at predetermined trigger prices according, to a formula with publicly known parameters, at market openings and reopenings only. JS are concerned, however, that this would result in capital being ”supplied by issuing corporations in a mandated, knee-jerk fashion that is, automatically and inflexibly.” 13ut I know of no alternative for preventing price manipulation, avoiding gaming against the corporations, anti assuring investors that a company is indeed committed to providing liquidity. JS’s comment focuses specifically on issues concerning leverage, trading halts and call auctions, and information arrival. I will respond to each in turn.