Financial Market Trading, Information and Volatility

Submission note: A thesis submitted in total fulfilment of the requirements for the degree of Doctor of Philosophy to the Department of Economics and Finance, La Trobe Business School, College of Arts, Social Sciences and Commerce, La Trobe University, Victoria, Australia.

Building on the theoretical reasonings on why investors trade or why trading volume arises, this thesis comprises three essays regarding financial market trading activity, price volatility and the trading venue where investors choose to execute their trades. The first essay investigates the information content of the limit order book (LOB) in the crude oil futures market. The analysis is rooted in the theoretical proposition developed by Foucault et al. (2007) that the LOB serves as a conduit for volatility information. By proposing a time-weighted LOB slope that incorporates the duration of each bid and ask update, the first essay asserts that the newly developed timeweighted LOB slope decreases significantly before weekly information releases when price volatility is anticipated to increase. It then bounces back quickly, restoring a level similar to the one before the information announcement with a large number of depth updates as the new information is disseminated and digested. More importantly, utilising a vector autoregressive (VAR) model, it documents a strong negative relationship between the time-weighted LOB slope and one-day ahead volatility after controlling for endogenously determined trade-related metrics. These include the number of trades, average trade size and order imbalance. Overall, the results provide strong empirical evidence in the crude oil futures market for the theoretical proposition of Foucault et al. (2007) that the LOB serves as a conduit for volatility information. The second essay examines the impact of short selling activity on trading activity and price volatility in the U.S. corporate bond market. Consistent with previous literature, Chapter 3 shows that investors use short selling as a platform to express their difference of opinion (Bessembinder et al., 1996). More specifically, the second essay contends that the positive relationship between short selling activity and price volatility weakens during the period when investors’ expectations tend to be more homogenous, for example the Global Financial Crisis (GFC). Finally, the second essay shows that short selling in the corporate bond market is not merely a substitute for equity short selling and options trading for investors to trade negative news and information against the underlying company. It also serves as an independent conduit for investors to express their divergent opinions specific to a bond. The third essay looks at the interaction between liquidity and informed investors from the perspective of their lit and dark venue choice to execute trades. The third essay exploits the exogenously instituted minimum tick size change, specifically to examine the dynamic relationship between the bid-ask spread in the lit market and dark trading activity in the exchange-operated dark pool in Japan. Using a difference–in– differences methodology, it documents a significant treatment effect where stocks affected by the minimum tick size change have a smaller share of trading in the exchange-operated dark pool. Overall, empirical findings in the third essay provide first-hand evidence that a significant amount of dark trading is liquidity-seeking instead of informed trading. Reducing minimum tick size can help lit venues regain market shares back from dark venues.