Transaction costs are important for a host of empirical analyses from market efficiency to intern... more Transaction costs are important for a host of empirical analyses from market efficiency to international market research. But transaction costs estimates are not always available, or where available, are cumbersome to use and expensive to purchase. We present a model that requires only the time series of daily security returns to endogenously estimate the effective transaction costs for any firm, exchange, or time period. The feature of the data that allows for the estimation of transaction costs is the incidence of zero returns. Incorporating zero returns in the return-generating process, the model provides continuous estimates of average round-trip transaction costs from 1963 to 1990 that are 1.2% and 10.3% for large and small decile firms, respectively. These estimates are highly correlated (85%), with the most commonly used transaction cost estimators. How much does it cost to trade common stock? The Plexus Group (1996) estimated that trading costs are at least 1.0-2.0% of market value for institutions trading the largest NYSE/AMEX firms. Such trades account for more than 20% of reported trading volume. Stoll and Whaley (1983) reported quoted spread and commission costs of 2.0% for the largest NYSE size decile to 9.0% for the small decile. Bwardwaj and Brooks (1992) reported median quoted spread and commission costs between 2.0% for NYSE securities with prices greater than $20.00 and 12.5% for securities priced less than $5.00. These costs are important in determining investment performance and "can substantially reduce or possibly outweigh the expected value created by an investment strategy" [Keim and Madhavan (1995)]. This article is based on a portion of the first chapter of David A. Lesmond's dissertation entitled: "Transaction Costs and Security Return Behavior: The Effect on Systematic Risk Estimation and Firm Size." We wish to thank the editor, Wayne Ferson, and an anonymous referee for their numerous comments in improving this manuscript. David A. Lesmond wishes to thank Paul Laux for adding to the understanding of the model. We also thank
We model a microstructure effect on daily security returns, embodied by zero returns and the bid-... more We model a microstructure effect on daily security returns, embodied by zero returns and the bid-ask spread, and derive a closed-form solution for the resulting bias in the estimated idiosyncratic volatility. Our empirical tests show that controlling for the bias eliminates the ability of idiosyncratic volatility estimates to predict future returns. We also find a significant reduction in the pricing
We provide a model to estimate bond liquidity costs using only daily prices. Our liquidity estima... more We provide a model to estimate bond liquidity costs using only daily prices. Our liquidity estimates are 30% correlated with the bid-ask spread and are within five basis points of the bid-ask spread for investment grade bonds. Our median liquidity estimates are approximately $0.15 for investment grade bonds which compares well with those established by Schultz (2001) or Hong and Warga (2000). Regression tests indicate that our estimate of liquidity is associated with the bid-ask spread even after controlling for the commonly used liquidity determinants. Assessing the economic significance of our liquidity estimate in relation to the yield spread, we find that our estimate of liquidity is positively associated with the yield spread regardless of controlling for the commonly used yield spread determinants. These results imply that liquidity costs exact an demonstrable influence on bond returns and are consequently a priced element of the yield spread.
Emerging markets are characterized by volatile, but substantial returns that can easily exceed 75... more Emerging markets are characterized by volatile, but substantial returns that can easily exceed 75% per annum. Balancing these lofty returns are liquidity costs that, using the bid-ask spread as a basis, range from 1% for the Taiwanese market to over 47% for the Russian market. However, the paucity of bid-ask spread information across countries and time requires the use of liquidity estimates in emerging markets even though little is known about the efficacy of these estimates in measuring bid-ask spread costs. Using firm-level quoted bid-ask spreads as a basis, I find that price-based liquidity measures of Lesmond et al. [Review of Financial Studies 12 (1999) 1113] and Roll [Journal of Finance 39 (1984) 1127 perform better at representing cross-country liquidity effects than do volume based liquidity measures. Within-country liquidity is best measured with the liquidity estimates of either Lesmond, Ogden, and Trzcinka or, to a lesser extent, Amihud (2002). Examining the impact of legal origin and political institutions on liquidity levels shows that countries with weak political and legal institutions have significantly higher liquidity costs than do countries with strong political and legal systems, even to the exclusion of legal origin or insider trading enforcement. Higher incremental political risk is associated with a 10 basis point increase in ARTICLE IN PRESS www.elsevier.com/locate/jfec 0304-405X/$ -see front matter r for their excellent research support. All errors remain my responsibility. Ã Tel.: 1 504 865 5665; fax: 1 504 865 6751. E-mail address: dlesmond@tulane.edu. transaction costs, using the Lesmond, Ogden, and Trzcinka estimate, or a 1.9% increase in price impact costs, using the Amihud estimate. r 2005 Elsevier B.V. All rights reserved. JEL classification: G15; N20 ARTICLE IN PRESS 1 Adding to the import of the zero returns, Bekaert et al. (2003) find that the zero return liquidity proxy significantly predicts future returns in emerging markets, whereas the commonly used turnover liquidity proxy does not. D.A. Lesmond / Journal of Financial Economics ] (]]]]) ]]]-]]] 3
Thesis (Ph. D.)--State University of New York at Buffalo, 1995. Includes bibliographical referenc... more Thesis (Ph. D.)--State University of New York at Buffalo, 1995. Includes bibliographical references (417-434). Photocopy of typescript.
In markets with trading friction, the incorporation of information into market prices can be subs... more In markets with trading friction, the incorporation of information into market prices can be substantially delayed through a weakening of the arbitrage process. We re-examine the profitability of relative strength trading strategies (buying past strong performers and selling past weak performers) by testing the predictions of a friction-based explanation. We provide a model of price friction and then use this model to infer trading costs from investor behavior. We find that the execution of standard relative strength strategies requires large trading costs because of the type and frequency of securities traded such that trading costs prevent profitable relative strength investing. In the cross section, we find evidence that trading costs provide binding constraints to relative strength strategy profits. Relative strength returns are localized among low-price, poor performers and are increasing in investor transaction costs. We conclude that the delay in price adjustment for security...
This paper models a microstructure bias, driven by the bid-ask spread, that is evident in the pri... more This paper models a microstructure bias, driven by the bid-ask spread, that is evident in the pricing of aggregate firm-level risk embodied by the stock return variance estimates of Goyal and Santa-Clara (2003). Based on this theory, we empirically find that aggregate firm-level variance is insignificant when using quote midpoint-based returns or when using the component of aggregate firm-level variance that is orthogonal to the microstructure bias spanning the period 1927 to 2012. The bid-ask spread also explains the time-trend of aggregate firm-level volatility (Campbell, Lettau, Malkiel, and Xu, 2001) from 1962 to 1997, and obviates the cross-sectional relation between retail trading and future idiosyncratic volatility. Most importantly, we conclude that the bid-ask spread and the percentage of zero returns are more associated with future market returns than are any of the aggregate firm-level risk measures.
Liquidity risk is an important component of the yield spread on both corporate and sovereign bond... more Liquidity risk is an important component of the yield spread on both corporate and sovereign bonds in emerging markets, explaining about half as much of the yield spread as credit risk specific variables. Using three measures of liquidity, including estimates from a model extension of the limited dependent variable model of Lesmond, Ogden, and Trzincka (1999)) on a dataset of over 1600 bond-years spanning both crisis and boom periods in 16 countries, we provide valuable evidence on the magnitude of these effects and the differences in liquidity across sovereign and corporate issuers. In particular, we document that liquidity components increase as credit quality deteriorates for sovereign debt, while the reverse is true for corporate debt, and are the first study to examine the determinants of the rapidly expanding emerging market corporate debt sector. Liquidity is highly significant in explaining cross-sectional variation in yield levels and changes across rated and unrated categories, for both corporate and sovereign issuers, and appears to dominate credit risk in explaining cross-sectional variations in yield spreads for both corporate and sovereign debt instruments across all of the emerging markets examined.
ABSTRACT I examine the effect that liquidity costs, institutional holdings, and short sale constr... more ABSTRACT I examine the effect that liquidity costs, institutional holdings, and short sale constraints impose on the profitability of accrual based strategies. I find that the bulk of the trading profits is derived from the short side of the trade, but that this position suffers from high liquidity costs that reduces institutional holdings with consequent short sale constraints. Examining the accrual profits using microstructure information reveals that the extreme accrual portfolios are subject to reduced levels of uninformed trading that restricts the level of informed trading. These results suggest that accrual based returns are explainable by liquidity cost constraints, in conjunction with short sale constraints, and are entirely consistent with rational pricing.
ABSTRACT Closed end funds are puzzling because they often trade at a discount to net asset value.... more ABSTRACT Closed end funds are puzzling because they often trade at a discount to net asset value. Explanations for this pricing anomaly extend to investor sentiment (Lee et al., 1991), agency costs, or liquidity costs (Pontiff, 1996). This study will examine a unique sample of 40 emerging/developed market funds (that trade at discounts of more than -20\%) as well as 40 closed end funds that invest solely in U.S. equities (that trade at discounts of more than -10\%). However, this study will differ significantly from prior studies (see, for example, Pontiff, 1996) by examining the actual holdings of each of these funds from 1995 to 2010. Studying a large cross-section of closed ends funds that demonstrate a large disparity in discounts will allow for a through examination of determinants of these discounts, separating out investor sentiment, liquidity costs, or arbitrage holding costs, as potential explanations for the discount. The findings of this study will better focus future research on whether behavioral (sentiment) biases, agency costs (expenses) or rational trading (liquidity costs, or holding costs) can explain a pricing puzzle that has existed in finance for the past 30 years.
This paper investigates the hypothesis that market microstructure is an important determinant of ... more This paper investigates the hypothesis that market microstructure is an important determinant of stock-return kurtosis. We first develop a simple model where an informed investor has private information about the firm's fundamentals and marketmaker has private information about the nonfundamentals, particularly concerning the structure of noise-traders' demand. The model shows that these market frictions can generate significant kurtosis in asset return distribution. Consistently, findings in our empirical analyses support this conjecture. We find a positive and causal association between liquidity cost in stock market and kurtosis in stock return. This association is robust to various specifications, and different proxies for liquidity cost and return kurtosis. It is even present when we control for the endogeneity and reverse causality concerns. Our findings have implications for research in asset pricing and corporate finance, and also add to the knowledge of practitioners, especially from risk management perspective.
This paper investigates the relationship between capital structure and stock liquidity surroundin... more This paper investigates the relationship between capital structure and stock liquidity surrounding pure leverage recapitalizations. A substitution of debt for equity in the firm's capital structure concentrates private information in the remaining equity, increasing the informational asymmetry of the firm's equity, leading to increases in the firm's equity liquidity costs. Changes in the firm's leverage are associated with both changes in the probability of informed trading in the firm's stock and with changes in the firm's underlying equity liquidity even after controlling for changes in the commonly used liquidity, equity volatility, or capital structure choice control variables. In aggregate, leverage increasing firms experience an increase of 1% in the bid-ask spread and leverage decreasing firms experience a decrease of 2% in the bid-ask spread. We argue that leverage's effect on equity liquidity costs represents an economically relevant cost to debt usage, and this cost potentially reduces firm value relative to a zero transaction costs environment.
Transaction costs are important for a host of empirical analyses from market efficiency to intern... more Transaction costs are important for a host of empirical analyses from market efficiency to international market research. But transaction costs estimates are not always available, or where available, are cumbersome to use and expensive to purchase. We present a model that requires only the time series of daily security returns to endogenously estimate the effective transaction costs for any firm, exchange, or time period. The feature of the data that allows for the estimation of transaction costs is the incidence of zero returns. Incorporating zero returns in the return-generating process, the model provides continuous estimates of average round-trip transaction costs from 1963 to 1990 that are 1.2% and 10.3% for large and small decile firms, respectively. These estimates are highly correlated (85%), with the most commonly used transaction cost estimators. How much does it cost to trade common stock? The Plexus Group (1996) estimated that trading costs are at least 1.0-2.0% of market value for institutions trading the largest NYSE/AMEX firms. Such trades account for more than 20% of reported trading volume. Stoll and Whaley (1983) reported quoted spread and commission costs of 2.0% for the largest NYSE size decile to 9.0% for the small decile. Bwardwaj and Brooks (1992) reported median quoted spread and commission costs between 2.0% for NYSE securities with prices greater than $20.00 and 12.5% for securities priced less than $5.00. These costs are important in determining investment performance and "can substantially reduce or possibly outweigh the expected value created by an investment strategy" [Keim and Madhavan (1995)]. This article is based on a portion of the first chapter of David A. Lesmond's dissertation entitled: "Transaction Costs and Security Return Behavior: The Effect on Systematic Risk Estimation and Firm Size." We wish to thank the editor, Wayne Ferson, and an anonymous referee for their numerous comments in improving this manuscript. David A. Lesmond wishes to thank Paul Laux for adding to the understanding of the model. We also thank
We model a microstructure effect on daily security returns, embodied by zero returns and the bid-... more We model a microstructure effect on daily security returns, embodied by zero returns and the bid-ask spread, and derive a closed-form solution for the resulting bias in the estimated idiosyncratic volatility. Our empirical tests show that controlling for the bias eliminates the ability of idiosyncratic volatility estimates to predict future returns. We also find a significant reduction in the pricing
We provide a model to estimate bond liquidity costs using only daily prices. Our liquidity estima... more We provide a model to estimate bond liquidity costs using only daily prices. Our liquidity estimates are 30% correlated with the bid-ask spread and are within five basis points of the bid-ask spread for investment grade bonds. Our median liquidity estimates are approximately $0.15 for investment grade bonds which compares well with those established by Schultz (2001) or Hong and Warga (2000). Regression tests indicate that our estimate of liquidity is associated with the bid-ask spread even after controlling for the commonly used liquidity determinants. Assessing the economic significance of our liquidity estimate in relation to the yield spread, we find that our estimate of liquidity is positively associated with the yield spread regardless of controlling for the commonly used yield spread determinants. These results imply that liquidity costs exact an demonstrable influence on bond returns and are consequently a priced element of the yield spread.
Emerging markets are characterized by volatile, but substantial returns that can easily exceed 75... more Emerging markets are characterized by volatile, but substantial returns that can easily exceed 75% per annum. Balancing these lofty returns are liquidity costs that, using the bid-ask spread as a basis, range from 1% for the Taiwanese market to over 47% for the Russian market. However, the paucity of bid-ask spread information across countries and time requires the use of liquidity estimates in emerging markets even though little is known about the efficacy of these estimates in measuring bid-ask spread costs. Using firm-level quoted bid-ask spreads as a basis, I find that price-based liquidity measures of Lesmond et al. [Review of Financial Studies 12 (1999) 1113] and Roll [Journal of Finance 39 (1984) 1127 perform better at representing cross-country liquidity effects than do volume based liquidity measures. Within-country liquidity is best measured with the liquidity estimates of either Lesmond, Ogden, and Trzcinka or, to a lesser extent, Amihud (2002). Examining the impact of legal origin and political institutions on liquidity levels shows that countries with weak political and legal institutions have significantly higher liquidity costs than do countries with strong political and legal systems, even to the exclusion of legal origin or insider trading enforcement. Higher incremental political risk is associated with a 10 basis point increase in ARTICLE IN PRESS www.elsevier.com/locate/jfec 0304-405X/$ -see front matter r for their excellent research support. All errors remain my responsibility. Ã Tel.: 1 504 865 5665; fax: 1 504 865 6751. E-mail address: dlesmond@tulane.edu. transaction costs, using the Lesmond, Ogden, and Trzcinka estimate, or a 1.9% increase in price impact costs, using the Amihud estimate. r 2005 Elsevier B.V. All rights reserved. JEL classification: G15; N20 ARTICLE IN PRESS 1 Adding to the import of the zero returns, Bekaert et al. (2003) find that the zero return liquidity proxy significantly predicts future returns in emerging markets, whereas the commonly used turnover liquidity proxy does not. D.A. Lesmond / Journal of Financial Economics ] (]]]]) ]]]-]]] 3
Thesis (Ph. D.)--State University of New York at Buffalo, 1995. Includes bibliographical referenc... more Thesis (Ph. D.)--State University of New York at Buffalo, 1995. Includes bibliographical references (417-434). Photocopy of typescript.
In markets with trading friction, the incorporation of information into market prices can be subs... more In markets with trading friction, the incorporation of information into market prices can be substantially delayed through a weakening of the arbitrage process. We re-examine the profitability of relative strength trading strategies (buying past strong performers and selling past weak performers) by testing the predictions of a friction-based explanation. We provide a model of price friction and then use this model to infer trading costs from investor behavior. We find that the execution of standard relative strength strategies requires large trading costs because of the type and frequency of securities traded such that trading costs prevent profitable relative strength investing. In the cross section, we find evidence that trading costs provide binding constraints to relative strength strategy profits. Relative strength returns are localized among low-price, poor performers and are increasing in investor transaction costs. We conclude that the delay in price adjustment for security...
This paper models a microstructure bias, driven by the bid-ask spread, that is evident in the pri... more This paper models a microstructure bias, driven by the bid-ask spread, that is evident in the pricing of aggregate firm-level risk embodied by the stock return variance estimates of Goyal and Santa-Clara (2003). Based on this theory, we empirically find that aggregate firm-level variance is insignificant when using quote midpoint-based returns or when using the component of aggregate firm-level variance that is orthogonal to the microstructure bias spanning the period 1927 to 2012. The bid-ask spread also explains the time-trend of aggregate firm-level volatility (Campbell, Lettau, Malkiel, and Xu, 2001) from 1962 to 1997, and obviates the cross-sectional relation between retail trading and future idiosyncratic volatility. Most importantly, we conclude that the bid-ask spread and the percentage of zero returns are more associated with future market returns than are any of the aggregate firm-level risk measures.
Liquidity risk is an important component of the yield spread on both corporate and sovereign bond... more Liquidity risk is an important component of the yield spread on both corporate and sovereign bonds in emerging markets, explaining about half as much of the yield spread as credit risk specific variables. Using three measures of liquidity, including estimates from a model extension of the limited dependent variable model of Lesmond, Ogden, and Trzincka (1999)) on a dataset of over 1600 bond-years spanning both crisis and boom periods in 16 countries, we provide valuable evidence on the magnitude of these effects and the differences in liquidity across sovereign and corporate issuers. In particular, we document that liquidity components increase as credit quality deteriorates for sovereign debt, while the reverse is true for corporate debt, and are the first study to examine the determinants of the rapidly expanding emerging market corporate debt sector. Liquidity is highly significant in explaining cross-sectional variation in yield levels and changes across rated and unrated categories, for both corporate and sovereign issuers, and appears to dominate credit risk in explaining cross-sectional variations in yield spreads for both corporate and sovereign debt instruments across all of the emerging markets examined.
ABSTRACT I examine the effect that liquidity costs, institutional holdings, and short sale constr... more ABSTRACT I examine the effect that liquidity costs, institutional holdings, and short sale constraints impose on the profitability of accrual based strategies. I find that the bulk of the trading profits is derived from the short side of the trade, but that this position suffers from high liquidity costs that reduces institutional holdings with consequent short sale constraints. Examining the accrual profits using microstructure information reveals that the extreme accrual portfolios are subject to reduced levels of uninformed trading that restricts the level of informed trading. These results suggest that accrual based returns are explainable by liquidity cost constraints, in conjunction with short sale constraints, and are entirely consistent with rational pricing.
ABSTRACT Closed end funds are puzzling because they often trade at a discount to net asset value.... more ABSTRACT Closed end funds are puzzling because they often trade at a discount to net asset value. Explanations for this pricing anomaly extend to investor sentiment (Lee et al., 1991), agency costs, or liquidity costs (Pontiff, 1996). This study will examine a unique sample of 40 emerging/developed market funds (that trade at discounts of more than -20\%) as well as 40 closed end funds that invest solely in U.S. equities (that trade at discounts of more than -10\%). However, this study will differ significantly from prior studies (see, for example, Pontiff, 1996) by examining the actual holdings of each of these funds from 1995 to 2010. Studying a large cross-section of closed ends funds that demonstrate a large disparity in discounts will allow for a through examination of determinants of these discounts, separating out investor sentiment, liquidity costs, or arbitrage holding costs, as potential explanations for the discount. The findings of this study will better focus future research on whether behavioral (sentiment) biases, agency costs (expenses) or rational trading (liquidity costs, or holding costs) can explain a pricing puzzle that has existed in finance for the past 30 years.
This paper investigates the hypothesis that market microstructure is an important determinant of ... more This paper investigates the hypothesis that market microstructure is an important determinant of stock-return kurtosis. We first develop a simple model where an informed investor has private information about the firm's fundamentals and marketmaker has private information about the nonfundamentals, particularly concerning the structure of noise-traders' demand. The model shows that these market frictions can generate significant kurtosis in asset return distribution. Consistently, findings in our empirical analyses support this conjecture. We find a positive and causal association between liquidity cost in stock market and kurtosis in stock return. This association is robust to various specifications, and different proxies for liquidity cost and return kurtosis. It is even present when we control for the endogeneity and reverse causality concerns. Our findings have implications for research in asset pricing and corporate finance, and also add to the knowledge of practitioners, especially from risk management perspective.
This paper investigates the relationship between capital structure and stock liquidity surroundin... more This paper investigates the relationship between capital structure and stock liquidity surrounding pure leverage recapitalizations. A substitution of debt for equity in the firm's capital structure concentrates private information in the remaining equity, increasing the informational asymmetry of the firm's equity, leading to increases in the firm's equity liquidity costs. Changes in the firm's leverage are associated with both changes in the probability of informed trading in the firm's stock and with changes in the firm's underlying equity liquidity even after controlling for changes in the commonly used liquidity, equity volatility, or capital structure choice control variables. In aggregate, leverage increasing firms experience an increase of 1% in the bid-ask spread and leverage decreasing firms experience a decrease of 2% in the bid-ask spread. We argue that leverage's effect on equity liquidity costs represents an economically relevant cost to debt usage, and this cost potentially reduces firm value relative to a zero transaction costs environment.
A number of competing explanations have been offered as a rationale for the trend in idiosyncrat... more A number of competing explanations have been offered as a rationale for the trend in idiosyncratic variance that has been experienced over the past four decades. We establish a theoretical model linking a market microstructure bias with the industry-adjusted idiosyncratic variance (Campbell, Lettau, Malkiel, and Xu, 2001) or the risk-adjusted diosyncratic variance. Using this model’s predictions, we empirically show that the bid-ask spread eliminates the time trend in aggregate idiosyncratic variance. These results are robust across various exchanges, across various risk-based measures of idiosyncratic variance, and through time. Two natural experiments demonstrate that an exogenous shock to the bid-ask spread is associated with a subsequent decline in the aggregate idiosyncratic variance. The microstructure hypothesis dominates any of the alternative explanations, including uncertainty about profitability, earnings shocks, or growth options, for the trend in idiosyncratic variance.
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Papers by David Lesmond
(Campbell, Lettau, Malkiel, and Xu, 2001) or the risk-adjusted diosyncratic variance. Using this model’s predictions, we empirically show that the bid-ask spread eliminates the time trend in aggregate idiosyncratic variance. These results are robust across various exchanges, across various risk-based measures of idiosyncratic variance, and through time. Two natural experiments demonstrate that an exogenous shock to the bid-ask spread is associated with a subsequent decline in the aggregate idiosyncratic variance. The microstructure hypothesis dominates any of the alternative explanations, including uncertainty about profitability, earnings shocks, or growth options, for the trend in idiosyncratic variance.