Three essays on market microstructure
This dissertation studies price discovery processes, stock order imbalances, and trading patterns around seasoned equity offerings. First chapter studies how the volatility of a stock is affected by the trading activity of other stocks. I construct a model of price discovery process after a public announcement. New information generates differences of opinion among investors, and the differences generate pricing error and volatility. Investors can reduce their differences by consulting the prices of stocks affected by the same information. A stock’s volatility and pricing error is a decreasing function of peer stock trading activity, because investors can learn more from a larger price data. I test the implications of the model in NASDAQ stocks, and find that stocks with a larger opportunity to learn from peer stock prices have a lower volatility, a smaller pricing error, and a weaker tendency to mean-revert. Second chapter studies relation between information and stock order imbalance using corporate earnings announcements. Before information is publicly announced, order imbalance does not have a reliable predictive power for the upcoming announcements. When information is announced, order imbalance moves independently of the information, implying that market makers quickly adjust their quotes before trades take place. After the announcement, order imbalance has a positive correlation with past information. Third chapter studies the determinants of the buying / selling pattern around seasoned equity offerings (SEOs) and their effect on underpricing. I find that the trading pattern is mainly driven by market makers’ inventory management activity before an issue date and underwriters’ price support activity afterwards. I also find that SEO underpricing is decreasing in the amount of price support activity, after controlling for endogeneity and other known factors of underpricing. This result implies that underwriters can reduce issuer equity flotation costs by raising their price support activity, albeit at an added cost to the underwriter.