Essays on Financial Markets and Game Theory PDF Download

Author: Joshua Mollner
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Languages : en
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Book Description
Trading in financial markets has changed dramatically over the past decade: it has become largely automated and orders of magnitudes faster, and it has become spread out across many venues. Chapters 1 and 2 of this dissertation investigate how this transformation has affected market outcomes. Chapter 1 studies the effect of speed on market outcomes in a setting where information acquisition is endogenous. An increase in trading speed crowds out information acquisition by reducing the gains from trading against mispriced quotes. Thus, faster speeds have two effects on traditional measures of market performance. First, the bid-ask spread declines, since there are fewer informational asymmetries. Second, price efficiency deteriorates, since less information is available to be incorporated into prices. A tradeoff exists between the dual objectives of minimizing the bid-ask spread and maximizing price efficiency. We characterize the frontier of this tradeoff and evaluate several trading mechanisms within this framework. Despite its popularity, the limit order book mechanism generally does not induce outcomes on this frontier. We consider two alternatives: first, a small delay added to the processing of all orders except cancellations, and second, frequent batch auctions. Both induce equilibrium outcomes on this frontier. Chapter 2 investigates how an increase in the number of exchanges affects the bid-ask spread. The welfare consequences of increased exchange competition are theoretically ambiguous. While competition does place downward pressure on the bid-ask spread, this force may be outweighed by increased adverse selection that stems from additional arbitrage opportunities. We investigate this ambiguity empirically by estimating key parameters of the model using detailed trading data from Australia. The benefits of increased competition are outweighed by the costs of multi-venue arbitrage. Compared to the prevailing duopoly, we predict that the counterfactual spread under a monopoly would be 23 percent lower. Further, market design variations on the continuous limit order book would eliminate profits from cross-venue arbitrage strategies and reduce the spread by 51 percent. Finally, eliminating off-exchange trades, so-called dark trading, would reduce the spread by 11 percent. Chapter 3 introduces two new equilibrium refinements for finite normal form games. Both refinements incorporate the intuitive idea that a costless deviation by one player is more likely than a costly deviation by the same or another player. These refinements lead to new restrictions in games with three or more players. Furthermore, these refinements are applied to two well-known auction games: the generalized second price auction and the first-price menu auction. Both refinements select interesting equilibria in these games, and may be interpreted as providing a strategic foundation for the selections that others have made.