Market Microstructure Daniel Sungyeon Kim

1. Market MicrostructureDaniel Sungyeon Kim

2. “Next” by Michael Lewis

4. More on Jonathan Lebed Q: So is what he did illegal? Unethical? And why?

5. Insider Trading Q: What is the legal definition of insider trading?

6. More on Insider Trading Q: How would investigators try to uncover instances of insider trading?

7. More on Insider Trading Q: What other securities might you trade besides stocks?

8. Benefits of Prohibiting Insider Trading Q: What are the benefits of prohibiting insider trading?

9. Benefits of Prohibiting Insider Trading Q: Why would prohibiting insider trading make the markets more liquid?

10. Benefits of Prohibiting Insider Trading • Corporate control issues = agency problems between manager and others • If insider trading was legal, there would be two ways to compensate managers: • (1) Salary, bonus, and benefits • (2) Profits from insider trading

11. Benefits of Prohibiting Insider Trading Q: What kind of distortions would occur if managers could profit on insider trading?

12. Benefits of Prohibiting Insider Trading Managers will front-run corporate trading Ex: Many firms with excess cash have initiated share repurchase programs  viewed as a “good news” announcement Manager will buy stock before share repurchase program is announced Manager’s profit = cost to shareholders Prohibit insider trading  Eliminates all of these distortions

13. Costs of Prohibiting Insider Trading Q: What are the costs of prohibiting insider trading?

14. So, on balance, should insider trading be legal or illegal? • Legal • Illegal

15. Bhattacharya, Daouk, Jorgenson, and Kehr Q: What was the situation regarding insider trading in Mexico?

16. Insider Trading in Mexico • Focus on major firm-specific news events: • Earnings announcements • Dividend announcements • Bankruptcy announcements • Merger announcements

17. Given that there haven’t been any prosecutions of insider trading cases in Mexico, when a Mexican firm announces its earnings, dividends, etc. what do you think would be the impact on it’s stock price? • Larger impact than in the US • Similar impact to the US • Small or even zero impact

18. Impact on stock price • Small or even zero impact – info was incorporated much earlier due to insider trading

19. More on Insider Trading in Mexico Q: What is the difference between A shares and B shares?

21. Figure 7 Figure 7 = y axis is Cumulative Absolute Residuals that have been detrended – use absolute because some events are good news and others are bad news and detrended to get to the surpriseelement

22. Figure 7 Q: What do we see in Figure 7?

23. Figure 7 Q: Does this imply an arbitrage opportunity?

25. Figure 3 Figure 3 = No abnormal volume in the event window

27. Figure 4 Figure 4 = Spread for A shares declines (less adverse selection), but stays constant for B shares Summary: Evidence that insider trading has caused info to be incorporated long in advance (30 – 50 days in advance)

28. Bhattacharya and Daouk

29. Their Data • Key variables: (2) Establishment Date, (7) IT Law Existence, (8) IT Enforcement (mislabeled), (9) Index of shareholder rights, (10) Official liberalization date • Liberalization = better shareholders rights laws (one-share one vote, shareholders can mail proxies, cumulative voting, etc.) • 22 developed countries and 81 emerging countries • Q: Where did they get a lot of this data?

32. Insider Trading Regulations in the 20th Century Q: What do we see in Figure 1?

34. Returns, Volatility, and Turnover • Q: What do we see in Figure 2a before and after laws? • Q: What do we see in Figure 2b before and after enforcement?

35. Returns, Volatility, and Turnover Q: So what really matters: laws only or laws + enforcement?

37. How big is the impact of enforcement? • Panel B: “Raw returns” = monthly returns • Only IT enforcement is statistically significant (p-value less than .05) • How big is impact? Regression 4b:

38. How big is the impact of enforcement? -.0063 in monthly return X 12 = drop of 7.6% (in annual cost of capital due to enforcement!) This is probably an upper estimate – I am skeptical that it is quite so large, but it is definitely big

39. Specialist Execution Strategies Setup from Example #1 Question:  The specialist has discretion over how market orders are executed against the limit order book and on his/her own account. Consider: Then a Market Buy for 800 shares arrives. Here are three alternative ways to execute it.)

40. Specialist Execution Strategies • (A) Undercut All of the Limit Sells. • Specialist takes all 800 shares at $20.09. Beats the Limit Sells by price priority. • (B) Take the Remainder After the First Limit Sell. • First Limit Sell takes 200 shares at $20.10 and specialist takes the remaining 600 shares at $20.10 • (C) Take the Remainder After Both Limit Sells • First Limit Sell takes 200 shares at $20.10, second Limit Sell takes 350 shares at $20.11, and specialist takes remaining 250 shares at $20.11 • So, what is the best strategy from the specialist point of view? Which one maximizes the specialist’s profit?

41. What is the profit formulafor Strategy B = remainder after the first limit buy? • (2400)($20.05-$20.01) • (2400-200)($20.10-$20.05) • (2400-430)($20.05-$20.00) • (2400-430)($20.05-$20.01)

42. For market sells, what is the equation for when a specialist is indifferent between Strategy A undercut all of the limit buys and Strategy B remainder after the first limit buy? • X($20.09-$20.05)=(X-200)($20.10-$20.05) • X($20.05-$20.01)=(X-430)($20.05-$20.00) • X($20.05-$20.00)=(X-430)($20.05-$19.99) • X($20.10-$20.05)=(X-200)($20.11-$20.05)

43. For market sells, what is the equation for when a specialist is indifferent between Strategy B remainder after the first limit buy & Strategy C remainder after both limit buys? • (X-430)($20.05-$20.01) =(X-1110)($20.05-$20.00) • (X-200)($20.10-$20.05) =(X-550)($20.11-$20.05) • (X-200)($20.09-$20.05) =(X-550)($20.10-$20.05) • (X-430)($20.05-$20.00) =(X-1110)($20.05-$19.99)