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Theoretical analysis of the bid-ask bounce and Related Phenomena

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  • Lerner, Peter
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    Abstract

    I provide a theoretical model for two empirical phenomena observed in the NYSE and Nasdaq markets. First is the bid-ask bounce recently studied by Heston, Korajczuk and Sadka (HKS, 2008) for high-frequency data. Second is a temporary liquidity squeeze observed by Madureira and Underwood (2008) in the event studies. The model I invoke to explain empirical observations of those two groups of authors, is based on Easley, Kiefer, O’Hara and Paperman (EKHP, 1996) equations for informed trading. The estimation was performed by maximizing correlations between MCMC-generated paths and empirical time series, which also maximizes the entropy. My modeling rejects the rational expectation paradigm on a short-to-medium (15 min.to 2 days) time scale. I conclude that, given statistical uncertainty, roughly half of the bidask spread can be attributed to the arrival of new economic information and the other half to microstructure friction.

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    Bibliographic Info

    Paper provided by University Library of Munich, Germany in its series MPRA Paper with number 35929.

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    Date of creation: Dec 2010
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    Handle: RePEc:pra:mprapa:35929

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    Keywords: Market microstructure; EMH (Efficient Market Hypothesis); Nasdaq; High frequency finance; Autocorrelation of returns;

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    1. Hasbrouck, Joel, 2007. "Empirical Market Microstructure: The Institutions, Economics, and Econometrics of Securities Trading," OUP Catalogue, Oxford University Press, Oxford University Press, number 9780195301649, October.
    2. Steven L. Heston & Robert A. Korajczyk & Ronnie Sadka, 2010. "Intraday Patterns in the Cross-section of Stock Returns," Papers 1005.3535, arXiv.org.
    3. Madureira, Leonardo & Underwood, Shane, 2008. "Information, sell-side research, and market making," Journal of Financial Economics, Elsevier, Elsevier, vol. 90(2), pages 105-126, November.
    4. Glosten, Lawrence R. & Milgrom, Paul R., 1985. "Bid, ask and transaction prices in a specialist market with heterogeneously informed traders," Journal of Financial Economics, Elsevier, Elsevier, vol. 14(1), pages 71-100, March.
    5. Mandelker, Gershon, 1974. "Risk and return: The case of merging firms," Journal of Financial Economics, Elsevier, Elsevier, vol. 1(4), pages 303-335, December.
    6. Kyle, Albert S, 1985. "Continuous Auctions and Insider Trading," Econometrica, Econometric Society, Econometric Society, vol. 53(6), pages 1315-35, November.
    7. Keown, Arthur J & Pinkerton, John M, 1981. "Merger Announcements and Insider Trading Activity: An Empirical Investigation," Journal of Finance, American Finance Association, American Finance Association, vol. 36(4), pages 855-69, September.
    8. Easley, David, et al, 1996. " Liquidity, Information, and Infrequently Traded Stocks," Journal of Finance, American Finance Association, American Finance Association, vol. 51(4), pages 1405-36, September.
    9. Harris, Larry, 2002. "Trading and Exchanges: Market Microstructure for Practitioners," OUP Catalogue, Oxford University Press, Oxford University Press, number 9780195144703, October.
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