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Theoretical analysis of the bid-ask bounce and Related Phenomena

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  • Lerner, Peter

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.

Suggested Citation

  • Lerner, Peter, 2010. "Theoretical analysis of the bid-ask bounce and Related Phenomena," MPRA Paper 35929, University Library of Munich, Germany.
  • Handle: RePEc:pra:mprapa:35929
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    File URL: https://mpra.ub.uni-muenchen.de/35929/1/MPRA_paper_35929.pdf
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    References listed on IDEAS

    as
    1. Keown, Arthur J & Pinkerton, John M, 1981. "Merger Announcements and Insider Trading Activity: An Empirical Investigation," Journal of Finance, American Finance Association, vol. 36(4), pages 855-869, September.
    2. Harris, Larry, 2002. "Trading and Exchanges: Market Microstructure for Practitioners," OUP Catalogue, Oxford University Press, number 9780195144703.
    3. Steven L. Heston & Robert A. Korajczyk & Ronnie Sadka, 2010. "Intraday Patterns in the Cross-section of Stock Returns," Journal of Finance, American Finance Association, vol. 65(4), pages 1369-1407, August.
    4. Hasbrouck, Joel, 2007. "Empirical Market Microstructure: The Institutions, Economics, and Econometrics of Securities Trading," OUP Catalogue, Oxford University Press, number 9780195301649.
    5. Mandelker, Gershon, 1974. "Risk and return: The case of merging firms," Journal of Financial Economics, Elsevier, vol. 1(4), pages 303-335, December.
    6. 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, vol. 14(1), pages 71-100, March.
    7. Easley, David, et al, 1996. " Liquidity, Information, and Infrequently Traded Stocks," Journal of Finance, American Finance Association, vol. 51(4), pages 1405-1436, September.
    8. Kyle, Albert S, 1985. "Continuous Auctions and Insider Trading," Econometrica, Econometric Society, vol. 53(6), pages 1315-1335, November.
    9. Madureira, Leonardo & Underwood, Shane, 2008. "Information, sell-side research, and market making," Journal of Financial Economics, Elsevier, vol. 90(2), pages 105-126, November.
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    More about this item

    Keywords

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

    JEL classification:

    • G14 - Financial Economics - - General Financial Markets - - - Information and Market Efficiency; Event Studies; Insider Trading
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G19 - Financial Economics - - General Financial Markets - - - Other

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