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FMG-3: Information and Price Discovery
Costly Interpretation of Asset Prices
1University of Toronto; 2IESE Business School
We propose a model in which investors spend effort to interpret the informational content of asset prices. Due to cognitive ability limitations, investors have a cost to process information from prices, but they still choose optimal trading strategies given their beliefs. We show that as long as investors are not fully sophisticated, their interpretation of prices can inject noise into the price system, which serves as a source of endogenous noise trading. Compared to the standard rational expectations equilibrium, our setup features price momentum and yields higher return volatility and excessive trading volume. When investors can study market data to endogenize their sophistication level, research efforts can exhibit strategic complementarity, leading to multiple equilibria.
Order Flow Segmentation, Liquidity and Price Discovery: The Role of Latency Delays
1Wilfrid Laurier University; 2Bank of Canada
Latency delays - known as "speed bumps" - are an intentional slowing of order flow by exchanges. Supporters contend that delays protect market makers from high-frequency arbitrage, while opponents warn that delays promote market maker "quote fading". We construct a model of informed trading in a fragmented market, where one market imposes a latency delay. Delayed orders fill, with some probability,after all private information becomes public. A delay reduces information acquisition, but increases liquidity investor participation.
Informed investors migrate to the non-delayed exchange, widening its quoted spread; the quoted spread narrows at the delayed exchange. The combined effect is dichotomous: "short" latency delays lead to improved trading costs for liquidity investors, but worsening price discovery; sufficiently "long'' delays improve both.Beyond the impact latency-delayed exchanges on overall market quality, our results have implications for their effect on intraday trading dynamics.
Hidden in Plain Sight: Equity Price Discovery with Informed Private Debt
1Cornell University; 2Yale University
This paper examines how private information is (or is not) transmitted via prices across markets for related claims on firm cash flows. We show that equity markets fail to account for value relevant non-public information enjoyed by syndicated loan participants and reflected in publicly posted loan prices. A strategy that buys the equities of firms whose debt has recently appreciated and sells the equities of firms whose loans have recently depreciated earns as much as 1.4 to 2.2% alpha per month. The strategy returns are unaffected when focusing on loan returns that are publicly reported in the Wall Street Journal. However, when we condition on the subsample of equities held by mutual funds which also trade in syndicated loans, returns to the strategy are eliminated.
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Conference: EFA 2017
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