Liquid markets

by Ekkehart Boehmer Assistant Professor of Finance Mays Fellow

Most of my research focuses on how securities are traded. Market quality is important, because more liquid markets improve investors’ risk sharing and reduce corporations’ cost of capital. Thus, we need to understand how traders create and use liquidity, and how regulation and competition among markets affect their activities.

In recent work published in the Journal of Finance, Gideon Saar, Lei Yu and I demonstrate that providing traders with more information changes the way they trade, and we show that liquidity and the informativeness of share prices improve as a result. In a related paper published in the Journal of Financial Economics, I show that traders adapt well to different types of market structure. For example, NASDAQ offers faster trading, but the NYSE offers lower execution costs. I show that, as a result, traders trade differently on the two exchanges. Moreover, because they may value different aspects on each market, comparisons across market structures are problematic.

I have also investigated how competition among exchanges affects market quality. In a paper with Beatrice Boehmer in the Journal of Banking and Finance, we show that competition can improve liquidity substantially. Moreover, in a recent working paper with Bob Jennings and Li Wei, we show that regulators can influence the way markets compete by changing disclosure requirements. In 2001, the Securities and Exchange Commission required market centers to publish detailed reports of execution quality. We find that these disclosures are valuable to brokers, who must decide to which market they send their clients’ orders. The data disclosed via the rule are used in a way that increases price competition.

In two working papers I look at the information institutional traders have and how they affect share prices. Eric Kelley and I show that institutional stock ownership makes prices more accurate, and all investors and companies benefit from this greater accuracy. Charles Jones, Xiaoyan Zhang and I use proprietary data to see whether short sellers have information that is not (yet) reflected in prices. They do: Stocks with relatively heavy shorting underperform lightly shorted stocks by an average of 1.25 percent in the following month of trading (more than 15 percent on an annualized basis). These results are strongly consistent with the emerging consensus in financial economics that short sellers possess important information and their trades are important contributors to more efficient stock prices.

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