Papers by Kenneth Kavajecz
Social Science Research Network, 2006
Do bond investors demand credit quality or liquidity? The answer is both, but at different times ... more Do bond investors demand credit quality or liquidity? The answer is both, but at different times and for different reasons. Using data on the Euro-area government bond market, which features a unique negative correlation between credit quality and liquidity across countries, we show that the bulk of sovereign yield spreads is explained by differences in credit quality, though liquidity plays a nontrivial role, especially for low credit risk countries and during times of heightened market uncertainty. In contrast, the destination of large flows into the bond market is determined almost exclusively by liquidity. We conclude that credit quality matters for bond valuation but that, in times of market stress, investors chase liquidity, not credit quality. (JEL G10, G12) In times of economic distress, we often observe investors rebalance their portfolios toward less risky and more liquid securities, especially in fixed-income markets. This phenomenon is commonly referred to as a flight-to-quality and a flight-to-liquidity, respectively. While the economic motives of these two phenomena are clearly distinct from each other, empirically disentangling a flight-to-quality from a flight-to-liquidity is difficult because, as Ericsson and Renault (2006) show in the context of the corporate bond market in the United States, these two attributes of a fixed-income security (credit quality and liquidity) are usually positively correlated. For example, US Treasuries have less credit risk and are more liquid than corporate bonds. Thus, when we observe a decrease in corporate bond prices and an increase in Treasury prices, it is unclear whether this occurred because of credit or liquidity concerns. We gratefully acknowledge the helpful comments from seminar participants at
Social Science Research Network, 2011
The historical dynamics of financial exchange formation and closure are analyzed for a sample of ... more The historical dynamics of financial exchange formation and closure are analyzed for a sample of 19 countries from 1855 through 2010. We focus on the economic, technological, and regulatory factors that jointly determine the observed pattern of financial exchanges and whether those factors are consistent with existing financial theories in a time-series setting. The results suggest waves of formation and closure primarily driven by underlying structural change, not business-cycle fluctuations. We find that exchange births are positively correlated with economic growth and commodity booms, while closures are associated with advances in communications technology, such as telephone and the Internet, and heightened regulation, such as the 1934 Securities Exchange Act and state-level blue sky laws in the United States and the 1963 Stock Transfer Act in the United Kingdom.
We examine the role of price discovery in the U.S. Treasury market through the empirical relation... more We examine the role of price discovery in the U.S. Treasury market through the empirical relationship between orderflow, liquidity, and the yield curve. We find that orderflow imbalances (excess buying or selling pressure) can account for as much as 26 percent of the day-to-day variation in yields on days without major macroeconomic announcements. The effect of orderflow on yields is permanent and strongest when liquidity is low. All of the evidence points toward an important role of price discovery on understanding the behavior of the yield curve.
Review of Financial Studies, Mar 26, 2004
The apparent conflict between the level of resources dedicated to technical analysis by practitio... more The apparent conflict between the level of resources dedicated to technical analysis by practitioners and academic theories of market efficiency is a long-standing puzzle. We offer an alternative explanation for the value of technical analysis that is consistent with market efficiency -specifically, that it reveals information about liquidity provision. We find evidence consistent with the hypotheses that support and resistance levels coincide with peaks in depth on the limit order book and that moving average forecasts reveal information about the relative position of depth on the book. These results demonstrate that technical analysis can have value even in an efficient market, and provide a practical method for estimating the level of liquidity on the book.
Journal of Financial and Quantitative Analysis, Sep 1, 2005
The costs of implementing investment strategies represent a significant drag on the performance o... more The costs of implementing investment strategies represent a significant drag on the performance of mutual funds and other institutional investors. It is the responsibility of institutional investors, and in the interests of the individual investors they represent, to seek market mechanisms that mitigate trading costs. We investigate one such liquidity provision mechanism whereby liquidity demanders auction a set of trades as a package directly to potential liquidity providers. A critical feature of the auction is that the identities of the securities in the package are not revealed to the bidder. We demonstrate that this mechanism provides a transactions cost savings relative to more traditional trading mechanisms for the liquidity demander as well as an efficient way for liquidity suppliers to obtain order flow. We argue that the cost savings afforded this new mechanism are due to the potential for low-cost crosses with the bidder's existing inventory positions and through the longer trading horizon, and superior trading ability, of the bidders. This research suggests that the ability to innov ate via new liquidity provision mechanisms can provide market participants with transaction cost savings that cannot be easily duplicated on more traditional exchanges.
Social Science Research Network, 2008
Investors rebalance their portfolios as their views about expected returns and risk change. We us... more Investors rebalance their portfolios as their views about expected returns and risk change. We use empirical measures of portfolio rebalancing to back out investors' views, specifically, their views about the state of the economy. We show that aggregate portfolio rebalancing across equity sectors is consistent with sector rotation, an investment strategy that exploits perceived differences in the relative performance of sectors at different stages of the business cycle. The empirical footprint of sector rotation has predictive power for the evolution of the economy and future bond market returns, even after controlling for relative sector returns. Contrary to many theories of price formation, trading activity, therefore, contains information that is not entirely revealed by resulting relative price changes. (JEL E17, G11, G12) Beber is at the Cass Business School, City University London, and is also affiliated with CEPR; Brandt is at the Fuqua School of Business, Duke University, and is also affiliated with the NBER; and Kavajecz is at the Wisconsin School of Business, University of Wisconsin-Madison. We gratefully acknowledge the helpful comments from seminar participants at
Journal of Financial Economics, Apr 1, 2000
In addition, we thank Katharine Ross of the NYSE for the excellent assistance she provided retrie... more In addition, we thank Katharine Ross of the NYSE for the excellent assistance she provided retrieving and explaining the data. All remaining errors are our own. While this paper was initiated while Goldstein was the Visiting Economist at the NYSE, the comments and opinions expressed in this paper are the authors' and do not necessarily reflect those of the directors, members or officers of the New York Stock Exchange, Inc.
Journal of Financial Markets, Feb 1, 2006
We investigate the cross-section of 256 financial exchanges throughout the world. First, we empir... more We investigate the cross-section of 256 financial exchanges throughout the world. First, we empirically analyze the country characteristics that are related to having a financial exchange. Second, we investigate the determinants of an exchange's choice of trading mechanism, and third, we examine whether the presence of an exchange in a country impacts the domestic country's economy. We find that the main determinants for an exchange to exist in a country are the size of the economy, trade policy, foreign investment, development of the banking sector and the legal system. Our results show that the choice of trading mechanism depends on the number of assets traded and the legal system. Lastly, we find that the presence of an exchange is associated with a reduction in the growth of the monetary aggregates but is not associated with other measures of domestic growth and productivity.
Intermarket and Intramarket Ordeflow: Sector Rotation and Flights
Social Science Research Network, Aug 1, 2006
ABSTRACT Different asset classes and different sectors within the equity asset class exhibit diff... more ABSTRACT Different asset classes and different sectors within the equity asset class exhibit different performances with different economic conditions. For example, during an expansion phase of the business cycle, stocks are likely to outperform bonds and cyclical stocks will probably outperform non-cyclical stocks. Accordingly, active asset allocation strategies of mutual funds try to profit from these performance differential by implementing sector rotation strategies within the stock market and by timing the allocation to different asset classes. Some investment fund are even marketed with the specific aim of shifting funds across sectors that are likely to exhibit the best performances. Furthermore, there is evidence that the highest diversification benefits and return potential are achieved with rebalancing across sectors rather than across countries. This paper investigates the dynamics of orderflow in government bonds, corporate bonds, equities and sectors within the equity class along several dimensions. First, we measure the response of returns to orderflow imbalance (i.e., excess buying or selling pressure) of the same asset class/sector and of other asset classes/sectors. Second, we investigate the variation of the returns/orderflow relation through time. Specific market environments could make these relation stronger or weaker. For instance, in periods of high uncertainty about the evolution of the economy, we can expect to observe stronger relation of asset returns with orderflow imbalances in safe and risky asset classes (flight to quality and liquidity). Third, we study the economic determinants of orderflow in different asset classes/sectors. We are interested in understanding what are the key economic forces behind portfolio rebalancing and sector rotation strategies. A final and related questions is to investigate whether the sector rotation strategies that we infer from orderflow imbalances are any good in forecasting future economic conditions and thus in obtaining excess returns.
The historical dynamics of US financial exchanges
Financial History Review, Jul 14, 2021
The historical dynamics of entry and exit in the financial exchange industry are analyzed for a p... more The historical dynamics of entry and exit in the financial exchange industry are analyzed for a panel of 327 US exchanges from 1855 through 2012. We focus on economic, technological and regulatory factors. Using novel panel data evidence, we empirically test whether these factors are consistent with existing financial theories. We find that US exchanges are more likely to exit per year after the passage of the Securities Exchange Act. The telephone, literacy and regulation are robust predictors of financial exchange dynamics, whereby an upward trend in literacy is an important driver of exchange entry.
Social Science Research Network, 2002
The costs of implementing investment strategies represent a significant drag on the performance o... more The costs of implementing investment strategies represent a significant drag on the performance of mutual funds and other institutional investors. It is the responsibility of institutional investors, and in the interests of the individual investors they represent, to seek market mechanisms that mitigate trading costs. We investigate one such liquidity provision mechanism whereby liquidity demanders auction a set of trades as a package directly to potential liquidity providers. A critical feature of the auction is that the identities of the securities in the package are not revealed to the bidder. We demonstrate that this mechanism provides a transactions cost savings relative to more traditional trading mechanisms for the liquidity demander as well as an efficient way for liquidity suppliers to obtain order flow. We argue that the cost savings afforded this new mechanism are due to the potential for low-cost crosses with the bidder's existing inventory positions and through the longer trading horizon, and superior trading ability, of the bidders. This research suggests that the ability to innov ate via new liquidity provision mechanisms can provide market participants with transaction cost savings that cannot be easily duplicated on more traditional exchanges.
In addition, we thank Katherine Ross of the NYSE for the excellent assistance she provided retrie... more In addition, we thank Katherine Ross of the NYSE for the excellent assistance she provided retrieving and explaining the data. All remaining errors are our own. This paper was initiated while Michael Goldstein was the Visiting Economist at the New York Stock Exchange. The comments and opinions expressed in this paper are the authors ’ and do not necessarily reflect those of the directors, members or officers of the New York Stock Exchange, Inc. Trading Strategies during Circuit Breakers and Extreme Market Movements We study the trading strategies of NYSE market participants through their choice of venue, order type and timing during the turbulent October 1997 period. During this period, we find the implicit costs of supplying liquidity through the electronic limit order book becomes so high as to induce market participants to withdraw depth from the book, opting instead for the flexibility and discretion of floor
A Specialist's Quoted Depth as a Strategic Choice Variable," Working Paper
This paper presents a parsimonious model of a specialist choosing prices and depths jointly in or... more This paper presents a parsimonious model of a specialist choosing prices and depths jointly in order to maximize profits. The model delivers many of the empirical results concerning posted spreads and depths found in the literature. Specifically, the model predicts that (1) spreads will widen and depths will fall in response to an increase in the amount of adverse selection, (2) spreads will widen and depths will remain unchanged in the wake of an increase in price uncertainty, and (3) prices will shift upward and depth will be shifted from the ask side to the bid side of the market in the event that either expectations become more optimistic or the percentage of desired sales by liquidity traders increases. Furthermore, the constrained models show that prices and depths are used as substitutes. In particular, a narrow bid-ask spread induces small depth quotes whereas large depth quotes induce a wide bid-ask At the most basic level, the study of how assets are traded in financial ma...
Aronson + Partners Credit Suisse Asset Management EXXON
country. It was founded in 1969 through a grant from Oppenheimer & Company in honor of its late p... more country. It was founded in 1969 through a grant from Oppenheimer & Company in honor of its late partner, Rodney L. White. The Center receives support from its endowment and from annual contributions from its Members. The Center sponsors a wide range of financial research. It publishes a working paper series and a reprint series. It holds an annual seminar, which for the last several years has focused on household financial decision making. The Members of the Center gain the opportunity to participate in innovative research to break new ground in the field of finance. Through their membership, they also gain access to the Wharton School’s faculty and enjoy other special benefits.
SSRN Electronic Journal, 2013
The version presented here may differ from the published version. If citing, you are advised to c... more The version presented here may differ from the published version. If citing, you are advised to consult the published version for pagination, volume/issue and date of publication
Liquidity in the U. S. Treasury Market: Asymmetric Information and Inventory Effects
An analysis of the repurchase agreement market
Intermarket and Intramarket Ordeflow: Sector Rotation and Flights
Different asset classes and different sectors within the equity asset class exhibit different per... more Different asset classes and different sectors within the equity asset class exhibit different performances with different economic conditions. For example, during an expansion phase of the business cycle, stocks are likely to outperform bonds and cyclical stocks will probably outperform non-cyclical stocks. Accordingly, active asset allocation strategies of mutual funds try to profit from these performance differential by implementing sector rotation strategies within the stock market and by timing the allocation to different asset classes. Some investment fund are even marketed with the specific aim of shifting funds across sectors that are likely to exhibit the best performances. Furthermore, there is evidence that the highest diversification benefits and return potential are achieved with rebalancing across sectors rather than across countries. This paper investigates the dynamics of orderflow in government bonds, corporate bonds, equities and sectors within the equity class alon...
SSRN Electronic Journal, 2011
The historical dynamics of financial exchange formation and closure are analyzed for a sample of ... more The historical dynamics of financial exchange formation and closure are analyzed for a sample of 19 countries from 1855 through 2010. We focus on the economic, technological, and regulatory factors that jointly determine the observed pattern of financial exchanges and whether those factors are consistent with existing financial theories in a time-series setting. The results suggest waves of formation and closure primarily driven by underlying structural change, not business-cycle fluctuations. We find that exchange births are positively correlated with economic growth and commodity booms, while closures are associated with advances in communications technology, such as telephone and the Internet, and heightened regulation, such as the 1934 Securities Exchange Act and state-level blue sky laws in the United States and the 1963 Stock Transfer Act in the United Kingdom.
Review of Financial Studies, 2011
Investors rebalance their portfolios as their views about expected returns and risk change. We us... more Investors rebalance their portfolios as their views about expected returns and risk change. We use empirical measures of portfolio rebalancing to back out investors' views, specifically, their views about the state of the economy. We show that aggregate portfolio rebalancing across equity sectors is consistent with sector rotation, an investment strategy that exploits perceived differences in the relative performance of sectors at different stages of the business cycle. The empirical footprint of sector rotation has predictive power for the evolution of the economy and future bond market returns, even after controlling for relative sector returns. Contrary to many theories of price formation, trading activity, therefore, contains information that is not entirely revealed by resulting relative price changes. (JEL E17, G11, G12) Beber is at the Cass Business School, City University London, and is also affiliated with CEPR; Brandt is at the Fuqua School of Business, Duke University, and is also affiliated with the NBER; and Kavajecz is at the Wisconsin School of Business, University of Wisconsin-Madison. We gratefully acknowledge the helpful comments from seminar participants at
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Papers by Kenneth Kavajecz