Valenzuela Bravo, Marcela Andrea
(2013)
Essays on financial economics.
PhD thesis, London School of Economics and Political Science.
Abstract
This thesis consists of an introductory chapter, three main chapters, and a concluding chapter. In Chapter 2, my co-author and I provide new empirical evidencethat the distribution of liquidity has a strong in-sample and out-of-sample predictive power on intraday market volatility. To this end, we introduce a novel way of summarizing the relative depth provision in the whole limit order book. Our measure, global depth, considers the entire quoted depth and assigns weights decreasing with distance from the best quotes. We document that global depth outperforms alternative predictors of volatility, such as the bid-ask spread, standard depth variables, and measures of trading activity, in explaining the variations in market volatility. The third chapter, forthcoming in the Journal of Banking and Finance, investigates the effects of competition and signaling in a pure order driven market and examines the trading patterns of agents when walking through the book is not allowed. We show that the variables capturing the cost of a large market order are not informative for an impatient trader under this market mechanism. We also document that the competition effect is not present only at the top of the book but persistent beyond the best quotes. Moreover, we show that institutional investors’ order submission strategies are characterized by only a few pieces of the limit order book information. The fourth chapter provides evidence that implied correlation is a significant indicator of market-wide risk. From an aggregate perspective, I document that implied correlation explains an important fraction of the variation in market excess returns, with high implied correlation followed by an increase in subsequent market returns. The predictive power is stronger at a forecast of bimonthly, quarterly and semiannually return horizons and robust to the inclusion of standard predictors. Moreover, I show that the information content of the correlation risk premium on market returns is fully driven by the implied correlation. My findings indicate that periods of high market-wide correlation produce a deterioration of the investment opportunity set and, as a consequence, an increase in the equilibrium expected return.
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