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Essays in Financial Economics

Kottimukkalur Renganatha, Badrinath (2017)
Dissertation (150 pages)
Committee Chair / Thesis Adviser: Chordia, Tarun
Committee Members: Busse, Jeffrey ; Jegadeesh, Narasimhan ; Green, Clifton ; Dichev, Ilia
Research Fields: Finance
Keywords: Inattention; HFT; Limits to Arbitrage
Program: Laney Graduate School, Business
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My dissertation studies the behavior of investors in financial markets. My first essay investigates whether attention constraints lead investors to underreact to earnings news on days with large market movements (market moving days). Investors are less likely to trade on earnings announcements on market moving days compared to other days. Earnings on market moving days are accompanied by a lower immediate price and volume response, as well as a higher post-earnings announcement drift. Additionally, analysts are slow to revise estimates following earnings on market moving days. Prices respond slowly to earnings when macroeconomic announcements are surprising. The findings are consistent with investors paying more attention to market information as compared to firm-specific information. The second essay, co-authored with Tarun Chordia and Clifton Green, studies High Frequency Trading around macro releases. Prices of stock index exchange traded funds and index futures respond to macroeconomic announcement surprises within a tenth of a second, with trading intensity increasing ten-fold in the quarter second following the news release. Profits from trading quickly on announcement surprises are relatively small and decline in recent years. Trading profits also decrease with quote intensity. The speed of information incorporation increases in recent years and order flow becomes less informative, consistent with prices responding to news directly rather than indirectly through trading. Our evidence is consistent with increasing competition among low latency traders, which mitigates concerns about their speed advantage. The third essay investigates whether turnover volatility (TURNVOL) limits arbitrage. Mispricing is severe in the high TURNVOL stocks. Among overpriced (underpriced) stocks, the high TURNVOL stocks are the most overpriced (underpriced). Overpricing in high TURNVOL stocks is severe during high investor sentiment periods. The findings are consistent with TURNVOL limiting arbitrage. Further, the negative relationship between TURNVOL and average return is present only in difficult-to-short stocks. TURNVOL as a deterrent to arbitrage and arbitrage asymmetry together explain the negative TURNVOL-return relation documented in prior literature.

Table of Contents

Attention to Market Information and Underreaction to Firm Earnings on Market Moving Days 1

1. Introduction. 2

2. Literature and Hypothesis Development 7

3. Data and Methodology. 10

3.1 Data. 10

3.2 Variables. 11

3.3 Methodology. 13

4. Results. 14

4.1 Individual Investor Trading. 14

4.2 Price Response. 16

4.3 Volume Response. 19

4.4 Analyst Behavior. 20

4.5 Attention around Macro Announcements. 22

4.6 Firm Characteristics. 22

4.7 Robustness. 23

4.8 Strategic Scheduling of Poor Earnings. 25

4.9 Response of Aggregate Mutual Fund Flows. 26

4.10 Aggregate Trading Volume. 27

5. Conclusion. 27

Rent Seeking by Low Latency Traders: Evidence from Trading on Macroeconomic Announcements 29

1. Introduction. 30

2. Data and descriptive statistics. 35

2.1 Financial market data: S&P500 ETF and E-Mini Futures. 35

2.2 Macroeconomic Announcements. 36

2.3 Market Moving Events. 37

3. Market Response to Macroeconomic News. 38

3.1 Speed of Information Incorporation. 39

3.2 Trading and Quoting Activity. 41

4. Profitability of LLTs on Macroeconomic News. 43

5. Effect of Competition on Profits and Price Discovery. 47

5.1 Trend in Profits. 47

5.2 Effects of the SEC Naked Access Ban. 48

5.3 Effect of Competition on Profits. 49

5.4 Impact of Early Access to Macroeconomic News. 53

5.5 Effect of Competition on Price Discovery. 56

5.6 Trend in ETF-Futures Arbitrage Profits. 59

5.7 Discussion. 61

6. Conclusion. 62

Does Turnover Volatility Affect Arbitrage?. 65

1. Introduction. 66

2. Literature and Hypothesis Development 69

3. Data. 70

3.1 Variables. 71

4. Results. 73

4.1 Turnover Volatility and Mispricing. 74

4.2 Other measures of turnover volatility. 75

4.3 Effect of TURNVOL on arbitrage after controlling for other limiting factors to arbitrage 76

4.4 Sentiment and Mispricing. 78

4.5 Arbitrage Asymmetry and negative TURNVOL-return relation. 78

4.6 Individual stocks Fama-Macbeth analysis. 79

5. Conclusion: 80

References. 82

Figures. 89

Tables. 98


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