Essays on trades and security prices

Abstract

This thesis consists of three chapters that investigate the complex relation between security prices and trades of market participants. In the first chapter, I study the evolution of stock prices after trades with different underlying motives using a novel data set of portfolio transitions. Institutional specifics allow me to identify portfolio transition purchases and sales as most likely induced by information-related and liquidity-related factors, respectively. I find that purchases permanently shift stock prices to new levels; moreover, these price changes are more significant after large trades, trades in stocks with a high degree of information asymmetry, and trades that reflect new rather than stale information. At the same time, sales trigger only temporary price pressure effects that are reversed in the following weeks. Thus, my findings provide supporting evidence for a long-standing tenet of market microstructure stating that information-motivated and liquidity-motivated transactions generate different price dynamics. In the second chapter, I analyze the price dynamics in response to trades in more detail; in particular, I focus on the properties of price impact. I explore the following questions: (1) how the price impact coefficients relate to various stock characteristics and differ across trading venues; (2) how they evolve during execution of multi-trade "packages"; and (3) what functional form best describes price impact functions. Regarding most of these questions, there exists an extensive theoretical literature which provides interesting insights. Using a unique data set of portfolio transition trades, I document a number of empirical facts about price impact, some of which can not be easily explained by existing models.

(cont.) For instance, the price impact coefficients relate positively to the market capitalization and to the amount of noise trading; they increase during buy "packages" and decrease during sell "packages"; finally, total price impact is concave in trade size, fitting well the square-root specification, however, surprisingly, its permanent component is also non-linear. In the last chapter, based on joint work with Jiang Wang, we study how security prices affect trading strategies. The supply/demand of a security in the market is an intertemporal, not a static, object and its dynamics is crucial in determining market participants' trading behavior. We show that the dynamics of the supply/demand, rather than its static properties, is of critical importance to the optimal trading strategy of a given order. Using a limit-order-book market, we develop a simple framework to model the dynamics of supply/demand and its impact on execution cost. We demonstrate that the optimal execution strategy involves both discrete and continuous trades, not only continuous trades as previous work suggested. The cost savings from the optimal strategy over the simple continuous strategy can be substantial. We also show that the predictions about the optimal trading behavior can have interesting implications on the observed behavior of intraday volume, volatility and prices.