High-frequency data analysis

von: Nadine Hirte

Semester: 6

Table of Content

1 Introduction 1

2 Basic Facts  1

2.1 Financial Market 1
2.2 Market Microstructure  2
2.3 High-Frequency Data 4

3 Bid-Ask Spread  5

3.1 Definition 5
3.2 Approaches and Research 7
3.3 Roll-Model (1984)  9

4 Empirical Analysis of the Roll-Model 10

4.1 Data Analysis  11
4.2 Empirical Part  12
4.3 Conclusions  15

5 Final Remarks 15

Appendix 16

Bibliography  23
 

1 Introduction

Today the financial market becomes more complex and includes more competition. Reasons are trends like globalization, liberalization and lower-cost trading mechanism. The market microstructure research has the aim of an efficient market. It is focused on the structure of the financial market. The investigation becomes possible through the availability of high- frequency data. Those data exist especially in the United States and like that most of the research focuses this market. To explain the phenomena, which have been found adequate, models that fit the characteristics of high- frequency data have to be developed. The research is important to understand actions on the market as well as develop new efficient mechanism. One part of the market microstructure field is the bid-ask spread. It will be focus of this paper. In the first two parts it will be discussed theoretically. In the last part one model will be empirically analyzed and tested on its usefulness and validity.

The second part of this paper explains the basic elements surrounding the research of bid-ask spread. Those are the financial market, market microstructure as well as high-frequency data. In the following part the bid-ask spread itself, approaches, researches and models focussing the spread will be discussed. The model of Roll (1984) will be explained in detail. The last part will be the empirical analysis of the model of Roll. It is analyzed with data from the NASDAQ.

2 Basic Facts

In this chapter the basics of this paper will be discussed. The bid-ask spread is part of the market microstructure discussion. Market microstructure research aims at the financial market and is possible through the availability of high- frequency data. Those data are important for the statistical analysis of financial market phenomenon.

2.1 Financial Market

The financial market is a market where buyers and sellers contract to exchange financial instruments and services. There are different possibilities to characterize this market. The market can have a national or international dimension. Another alternative is the distinction between short- and long-term instruments that aims at the date when the financial transaction is completed. Former claims are mostly traded on money markets, latter ones on capital markets. The instruments used on the market can be primary or secondary ones. On the primary market the instruments are emitted and on the secondary one existing ones are traded.1 Those are the main characteristics. Each financial market is specified by its trading mechanism.

The main determinants of a trading mechanism are the market participants, the place and the rules. The market participants are buyers and sellers, who can contact each other directly as well as intermediaries, through which they can interact. One type of intermediary is the market maker. He is a specialist and quotes prices to buy or sell the asset. The place focuses on how the instruments are traded, on a central physical location or electronically. The rules determine how the process works. They contain what can be traded, who can trade, when and how orders can be submitted, who may see or handle the orders, how orders are processed and how prices are set. Each mechanism has its own set of rules like that it is not useful to describe each trading mechanism.2 One goal of a market is price discovery. The main alternatives therefore are the order-driven and quote-driven form. Former means that complete orders with price and volume are named. Latter contains a market maker. Today hybrid forms establish. 3 In general price discovery with intermediaries and without them is possible.

Many determinants influence the actions of the market, which have to be studied on the one hand, and are complicate to investigate on the other hand. The kind of traded goods, how the market participants are supplied with information, their perception about the future as well as institutional characteristics influence the price formation and how to do business.4 Other factors affecting the buying and selling behavior of traders and market makers are risk aversion, private information and wealth constraints.5

2.2 Market Microstructure

Market microstructure analyzes how specific trading mechanisms affect the price formation process. In other words it considers the structure or institutional characteristics of capital markets. The financial market can be formed in several ways and many determinants influence its actions like explained in 2.1. It is important to look how and by what returns are influenced as well as which market form is efficient and how it becomes efficient. The application of market microstructure is found in regulation of markets and in finding new trading mechanisms.6

Market microstructure aims at the secondary market, where existing instruments are traded. The neoclassic capital market models assume that all market participants have homogeneous expectations about the future. Prices for buyers and sellers are equal and thus they are price takers.7 Implicit the trading mechanism plays no role there.8 Furthermore it assumes perfect markets, free market entry and no transaction costs. The market microstructure on the other hand assumes an imperfect capital market, asymmetric information allocation and that the provision of information is not for free.9

The need to understand the relationship between competition, market structure and market quality is greater than ever. Reasons are current trends like globalization, liberalization of capital markets, democratization of information technology, development of new lower-cost trading mechanism and the expansion of derivatives markets in developed and emerging economies.10 Like that it is intensively researched now. Stocks compete for customers by means of service quality and pricing quality because there are increasing possibilities for investors, through the rise of new electronic communication networks.11

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1 See Heffernan (2002), pp. 1957 et seq.

2 See O’Hara (1995), pp. 7 et seqq.

3 See Cramer (1999), p. 229.

4 See Möller/Hüfner (2001), p. 1277.

5 See O’Hara (1995), p. 12.

6 See O’Hara (1995), p. 1.

7 See Cramer (1999) p. 1291.

8 See O’Hara (1995), p. 3.

9 See Neus/Hirth (2001), p. 1306.

10 See Mayhew (2002), p. 931.

11 See Freihube/Krahen/Theissen (2002), p. 255.