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Skrifter utgivna vid Svenska handelshögskolan

Publications of the Swedish School of Economics

and Business Administration

Nr 107





Helsingfors 2002 The Relationship between Liquidity, Trading Activity and Return - Studies of the Finnish and Swedish Stock Markets Key words: IPO, Market microstructure, Stabilization, Price support, Limit order book, Security Transaction Tax, Transaction cost, Transaction cost elasticity, Liquidity, Asset pricing, Amortized spreads © Swedish School of Economics and Business Administration & Joakim Westerholm Joakim Westerholm Swedish School of Economics and Business Administration Department of Finance and Statistics


Library Swedish School of Economics and Business Administration P.O.Box 479 00101 Helsinki, Finland Telephone: +358-9-431 33 376, +358-9-431 33 265 Fax: +358-9-431 33 425 E-mail: publ@shh.fi http://www.shh.fi/link/bib/publications.htm ISBN 951-555-731-3 ISSN 0424-7256 Yliopistopaino, Helsingfors 2002 iii Acknowledgements The learning process to reach the elusive goal of a PhD is both challenging and exciting. For me it was like growing up again, as I started my PhD studies after spending almost a decade in the financial industry. Now, being very close to the ultimate achievement of my life as a student it feels great to finally have grown up.

Recently however, I have realized that this feeling might be short lived and that the real challenge starts once you have the PhD.

To the Professors that have helped me along the way I would like to extend my sincere thanks for their patience in teaching an old dog new tricks. I wish to thank Professor Eva Liljeblom for her inspiring enthusiasm and support in giving me a go as a PhD student, and in helping me to choose the right area for specialization. I wish to thank Dr Kaj Hedvall for his invaluable insights into the field of Market Microstructure and for offering me his old hat as a representative for this field at Hanken. It remains to be seen if I was worthy of this honor. I would like to thank Professor Anders Löflund for early on giving me the opportunity to get experience in teaching. I also thank Anders and Professor Jukka Perttunen for their help with the finalization of my licentiate thesis. In my case this intermediate stepping stone on the way to a PhD proved to be the right choice, since it gave me the credibility to take part in challenging research projects at an early stage in my career as aresearcher. To Professor Peter Swan I am forever indebted for his patience in mentoring me as a researcher and for giving me the opportunity to acquire invaluable international experience both as a researcher and a teacher. Finally I want to thank Professor Tom Berglund for giving me a hard time at frequent seminars and in this way helping me to see where my theoretical and research skills need improving.

Among the numerous colleagues I have interacted with and received advice and encouragement from during these years I would like to mention: Kalle, Mats, Jan, Henrik, Thomas and Mika; from the earlier years: Slama, Simo, Kim and Markku;

from the later years: Tro, Henk, Giancarlo, Annika, Martin, Bernard, Andriy, Juhani, and Stella. Without your company this would not have been worth it. If I forgot to mention someone it is not intentional. Thanks to all my students for helping me to learn with them and for useful comments how to improve my teaching.

iv The generous support from the research foundations in Finland has been very encouraging. I hope that this dissertation and the related ongoing research projects at least to some extent fulfill their expectations. I wish to thank, OKOBANK Group Research Foundation, The Academy of Finland, Pörssisäätiö, Yrjö Jahnssonin säätiö, Svenska Kulturfonden, Waldemar von Frenckells stiftelse, Ella och Georg Ehrnrooths stiftelse, Stiftelsen for främjandet av värdepappersmarknaden i Finland and Bergsrådet Marcus Wallenbergs stiftelse. Without their support I would never have come this far and would not be able to continue from here.

Thanks to my parents for all their patient and limitless support, thanks to Christina for surviving all those nights with an absent minded researcher glued to the computer and thanks to my kids for understanding why their dad is away on long trips overseas.

In Sydney 8th of August, 2002

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3. The impact of transaction costs on turnover and asset prices; The cases of Sweden’s and Finland’s security transaction tax reductions. 61

–  –  –

1 Introduction Liquidity, or how easy an investment is to buy or sell, is becoming increasingly important in financial markets. The increase in institutional holdings of securities and the relatively active investment strategies employed by institutions lead to a higher demand for liquid investments. In relatively small markets as the Nordic markets for common stock, liquidity tends to be concentrated to a few companies while the daily buying and selling interest does not reach all less widely held stocks. This poses a challenge for market designers and is a major concern when new companies are listed.

The increased demand for liquidity is an important reason for the ongoing discussions of alliances and mergers between European exchanges. If liquidity is regarded as a positive factor then a lack of liquidity would be expected to have a negative impact on the valuation of the less liquid companies.

The objective of this dissertation is to contribute to the understanding of how liquidity affects financial markets. When frictions such as legal restrictions on trading or transaction taxes change, liquidity is affected. Policy changes and changes in market structures that have been made to overcome such market frictions also have an impact on liquidity. I investigate how these liquidity increasing or decreasing changes affect turnover and asset prices. Both the introduction of new companies to the exchange and the daily trading of securities are included in this study of samples of common stock from Finland and Sweden. In a short time these two financial markets have developed from relatively closed, highly taxed and not so competitive markets to relatively open, efficient, and competitive markets. This development in combination with good data availability makes these markets excellent laboratories. I investigate common stocks as opposed to other financial instruments or markets for the traditional reasons, data availability is good, the markets are highly transparent and all participants have more or less equal access to the same information and abilities to act on it. Short-term interest rates are however included as an alternative investment through all my studies.

The methods I apply and develop are empirical and draw on recent developments in the market microstructure discipline of finance. Studies of market microstructure are concerned with the functionality of markets taking into consideration real world restrictions and frictions that might delay or complicate the process when market prices move towards a equilibrium, where all available information is reflected in prices. The methodologies developed within this discipline give opportunities to take a new look at the unsolved puzzles of finance. In this dissertation my main goal is to determine if liquidity is priced on the Finnish and Swedish stock markets. I also apply recently proposed new ways to measure the effects of liquidity.

2 Definitions and measures of liquidity.

Hasbrouck and Schwartz (1988) point out that the concept of liquidity is widely used but not easily defined nor readily measured. They develop a method of quantifying liquidity and present three characteristics that can be used to describe the liquidity of an equity market. These are depth, breadth and resiliency. Depth describes the existence of orders on both sides of the order book near the price at which shares are currently trading. Depth is lacking when the bid-ask spread is large or when prices are rounded substantially to the nearest even number. Breadth describes the existence of orders in substantial volume. Breadth is lacking when the effective spread or the difference between the mid-point of the bid-ask spread and the execution price for large orders is large. Resiliency describes the responsiveness of new orders to price changes caused by temporary order imbalances. Resiliency is lacking when the order flow does not adjust quickly to errors in price discovery. Hasbrouck and Schwartz also conclude that execution costs depend on individual characteristics of the asset traded, the design of the trading system and on the trading strategies used by market participants. Passive traders who post limit orders and wait for the contra side to come to them may avoid execution costs or even profit from them. Active traders who seek immediate transactions generally incur transaction costs.

Madhavan (2000) defines market microstructure as the area of finance that studies the process by which investors’ latent demands are ultimately translated into prices and volumes. The growing interest in market microstructure is most obviously driven by the rapid structural, technological, and regulatory changes affecting the securities industry world-wide. The way the financial markets are set up has implications for asset pricing, corporate finance, and international finance. According to Madhavan a central idea in the theory of market microstructure is that asset prices need not equal full-information expectations of value because of a variety of frictions. Thus, market microstructure is closely related to the field of investments, which studies the equilibrium values of financial assets. But while many regard market microstructure as a sub-field of investments, it is also linked to traditional corporate finance because differences between the price and value of assets clearly affects financing and capital structure decisions. Madhavan points out that the analysis of interactions with other areas of finance offer a new and exciting dimension to the study of market microstructure, one that is still being written. Asset pricing is one of the areas of finance where market microstructure acts as on interface between different areas of finance.

In her analysis of market microstructure theory, O’Hara (1995) discusses the fundamental role liquidity plays in markets. She points out that in addition to the obvious positive side of liquidity there is a dark side that is usually unseen. While the ability to trade essentially costlessly, may benefit the individual, it may impose costs on the market by allowing the flight of investors away from less liquid securities and markets. While better liquidity is good for all market participants, markets have to be designed to not take too much liquidity away from some securities when the liquidity is improved for others. Madhavan (2000) concludes that there is growing support for the idea that expected returns must reflect compensation for illiquidity starting with Amihud and Mendelson (1986a). In recent market microstructure oriented papers new theory and empirical findings have been presented on the role of liquidity in asset pricing and on if variation in expected returns across securities arises because of differences in trading costs.

Since transaction costs are a central determinant of liquidity and since market microstructure specifically recognizes such frictions, it is natural that the lessons of market microstructure research will be applied in studies of liquidity. Market microstructure is a new science however and while it provides a number of tools for measuring liquidity that utilizes higher frequency data and information on the order book etc. it does not give any definite answers when to use a particular measure. The bid-ask spread with its limitations as a liquidity measure has been established with more sophisticated improvements to it as the effective spread and the amortized spread.1 Other measures that are more demanding regarding data availability are measures of depth of the order book and market impact of trades. It seems that the most useful measures however are the ones that can be summarized into daily, weekly or monthly measures so that traditional and established methodology can be applied to traditional cross sectional and time series data. This is particularly the case when traditional puzzles in finance such as the equity premium puzzle are addressed.

Another approach would be to develop new methods that take into account that high frequency intra-day data is not continuously spread over time. Engle (2000) presents such a method.

A generally accepted concept is that risk-averse investors require higher expected returns to compensate for greater risk. Similarly, investors would be expected to prefer to commit capital to marketable or liquid investments, which can be traded quickly and at low cost. This is the aspect of liquidity addressed in this thesis.

3 Primary Markets: New listings of companies and what affects the liquidity of these securities There are not many studies that directly assess the importance of liquidity for initial public offerings [IPOs]. Anecdotal observations of a relationship between the success of IPOs and their liquidity in the aftermarket have been presented by practitioners.

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