Information and trading patterns in financial markets

Abstract

This thesis consists of three chapters, each with implications on information and trading patterns in financial markets. Chapter 1: In most financial markets, dealers are given trading advantages meant to encourage liquidity provision. However, it is unclear if these advantages truly induce such trading. I test a unique dataset containing weekly trades and transaction prices of all dealers from the Taiwan Stock Exchange. Standard market-making models, such as Kyle (1985) and Grossman and Miller (1988), imply market maker trades and contemporaneous returns are negatively correlated. I find a strong positive correlation, implying that dealers do not provide liquidity. I develop a unique profit decomposition and find that dealers earn significant excess returns, in aggregate driven by information profits. Chapter 2: I explore cross-sectional returns earned with respect to trading strategies of dealers on the Taiwan Stock Exchange. First, I document the wide variation in dealer trading strategies, as measured by the correlation of their trades with stock returns, as well as the variation in total returns as well as information and market-making components of return. I find no characteristics that provide significant explanatory power for total returns, but several that significantly affect the individual components of returns. Information returns are strongly increasing in the correlation between contemporaneous dealer trades and stock returns. Market-making returns are decreasing in dealer size, number of stocks actively traded, and the aforementioned correlation. These results suggest that a policy of small dealers trading exclusively in a few stocks would be optimal to encourage market-making profits. Ironically, small dealers would be unable to absorb

(cont.) large liquidity imbalances. Chapter 3 (joint with Kin Wai Chan and Charles Chang): We explore how financial firms trade on in-house, US equity recommendations. We match the quarterly trades of financial firms with their own recommendations and document their trading patterns around recommendations. We find that net trade is generally more positive around upgrades than downgrades, and significantly so in the same quarter and quarter after the recommendation change. These empirical relations suggest that by and large, financial firms actually do "put their money where their mouths are".