Three essays in asset pricing

Li, Sida

Permalink

https://hdl.handle.net/2142/115476 Copy

Description

Title

Three essays in asset pricing

Author(s)

Li, Sida

Issue Date

2022-04-22

Director of Research (if dissertation) or Advisor (if thesis)

Ye, Mao

Doctoral Committee Chair(s)

Ye, Mao

Committee Member(s)

• Johnson, Timothy
• Pearson, Neil
• Pennacchi, George

Department of Study

Finance

Discipline

Finance

Degree Granting Institution

University of Illinois at Urbana-Champaign

Degree Name

Ph.D.

Degree Level

Dissertation

Keyword(s)

• Asset Pricing
• Market Microstructure
• High-Frequency Trading
• Exchange-Traded Funds (ETFs)
• Algorithmic Trading
• Liquidity

Abstract

This thesis summarizes my research works in asset pricing and market microstructure. The first chapter of this thesis provides the anatomy of the order types on U.S. stock exchanges. The Regulation National Market System (Reg NMS) links fragmented stock exchanges by routing orders to the National Best Bid and Offer (NBBO). As the NBBO ignores exchange fees, 62% of routings lead to worse net prices. An increase in fee differences increases the market share captured by orders that refuse Reg NMS routings, particularly for stocks whose fees account for a large portion of transaction costs. Heterogeneous opportunity costs rationalize routing choices: non-routable orders entail lower non-execution costs than routable orders. Our results indicate that fees and clientele segmentation drive the proliferation of order types in the Reg NMS era. The second chapter of this thesis proposes a liquidity model for U.S. equities and solves optimal nominal prices of stocks. Economists commonly assume that price and quantity are continuous variables, while in reality both are discrete variables. As U.S. regulation mandates a one-cent minimum tick size and a 100-share minimum lot size, we predict that less volatile stocks and more active stocks should choose higher prices to make pricing more continuous and quantity more discrete. Despite heterogeneous optimal prices, all firms achieve their optimal prices when their bid–ask spreads equal two ticks, when frictions from discrete pricing equal those from discrete lots. Empirically, our theoretical model explains 57% of cross-sectional variations in stock prices and 81% of cross-sectional variations in stock liquidity. We find that most stock splits move the bid–ask spread closer to two ticks and that correct splits contribute 94 bps to split announcement returns. Optimal pricing can increase median U.S. stock value by 106 bps and total U.S. market capitalization by $93.7 billion. The third chapter of this thesis discusses the optimal rebalance strategy for passive investors. Using novel daily holding data for exchange-traded funds (ETFs), I identify three types of ETFs that adopt distinct approaches to rebalancing their portfolios, which generates meaningful return heterogeneity. First, 56% of ETFs track public indices that pre-announce their rebalances, and they trade entirely on reconstitution days at closing prices. Their large, uninformed trades pay 67 bps in execution costs, a figure that is three times higher than what is paid in similar-sized institutional trades. Second, 7% of ETFs spread out their trades across 10 days and save 34 bps per trade or 7.3 bps per year. Third, 37% of ETFs use self-designed indices to avoid pre-announcements of rebalancing stocks and save 30 bps per trade. The alternative rebalance schedule leads to a tracking error of 10.6 bps per year and an information ratio of 0.69. For a $2 million retirement account that accrues over 30 years, the transaction cost savings rise to $29 thousand at retirement. These three chapters, combine with an article published on the Journal of Financial Economics (available at https://doi.org/10.1016/j.jfineco.2021.04.020), constitutes of my research works during my Ph.D. studies.

Graduation Semester

2022-05

Type of Resource

Thesis

Copyright and License Information

Copyright 2022 Sida Li

Owning Collections