The Journal of Finance

Presidential Address: Liquidity and Price Discovery

Published: 07/15/2003   |   DOI: 10.1111/1540-6261.00569

Maureen O'Hara

This paper examines the implications of market microstructure for asset pricing. I argue that asset pricing ignores the central fact that asset prices evolve in markets. Markets provide liquidity and price discovery, and I argue that asset pricing models need to be recast in broader terms to incorporate the transactions costs of liquidity and the risks of price discovery. I argue that symmetric information‐based asset pricing models do not work because they assume that the underlying problems of liquidity and price discovery have been solved. I develop an asymmetric information asset pricing model that incorporates these effects.

Presidential Address: Liquidity and Price Discovery

Published: 07/15/2003   |   DOI: 10.1111/1540-6261.00569

Maureen O'Hara

This paper examines the implications of market microstructure for asset pricing. I argue that asset pricing ignores the central fact that asset prices evolve in markets. Markets provide liquidity and price discovery, and I argue that asset pricing models need to be recast in broader terms to incorporate the transactions costs of liquidity and the risks of price discovery. I argue that symmetric information‐based asset pricing models do not work because they assume that the underlying problems of liquidity and price discovery have been solved. I develop an asymmetric information asset pricing model that incorporates these effects.

DISCUSSION

Published: 07/01/1987   |   DOI: 10.1111/j.1540-6261.1987.tb04568.x

MAUREEN O'HARA

A Dynamic Theory of the Banking Firm

Published: 03/01/1983   |   DOI: 10.1111/j.1540-6261.1983.tb03630.x

MAUREEN O'HARA

Dynamic analysis has greatly increased our understanding of the microfoundations of the general firm. Unfortunately, however, little attention has been focussed on the dynamic nature of the banking firm. Instead, most theoretical work has derived the optimal behavior for the bank in a single period context. This approach, while yielding insight into the function of the bank as a broker between borrowers and lenders, has proven incapable of capturing many essential elements of the banking firm. The role of capital, for example, is understated if the risk of bankruptcy is not considered. Perhaps more importantly, the role of banks in transforming risks in an uncertain environment cannot be captured if the problem of handling these risks over time is not considered. This paper incorporates these dual roles of brokerage and risk transformation in a cohesive model of the banking firm.

Time and the Process of Security Price Adjustment

Published: 06/01/1992   |   DOI: 10.1111/j.1540-6261.1992.tb04402.x

DAVID EASLEY, MAUREEN O'HARA

This paper delineates the link between the existence of information, the timing of trades, and the stochastic process of prices. We show that time affects prices, with the time between trades affecting spreads. Because the absence of trades is correlated with volume, our model predicts a testable relation between spreads and normal and unexpected volume, and demonstrates how volume affects the speed of price adjustment. Our model also demonstrates how the transaction price series will be a biased representation of the true price process, with the variance being both overstated and heteroskedastic.

Microstructure and Ambiguity

Published: 09/21/2010   |   DOI: 10.1111/j.1540-6261.2010.01595.x

DAVID EASLEY, MAUREEN O'HARA

A goal for stock exchanges is to increase participation by firms and investors. We show how specific features of the microstructure can reduce perceived ambiguity, and induce participation by both investors and issuers. We develop a model with sophisticated traders, who we view as expected utility maximizers with rational expectations, and unsophisticated traders, who we view as rational traders facing ambiguity about the payoffs to participating in the market. We show how designing markets to reduce ambiguity can benefit investors through greater liquidity, exchanges through greater volume, and issuing firms through a lower cost of capital.

Order Form and Information in Securities Markets

Published: 07/01/1991   |   DOI: 10.1111/j.1540-6261.1991.tb03771.x

DAVID EASLEY, MAUREEN O'HARA

This paper examines the effects of price‐contingent orders on security prices. We show that a market maker who knows the type and composition of trades will set larger spreads and adjust prices faster than if price‐contingent orders were not allowed. Because traders have rational expectations over the book, we demonstrate that uncertainty over order type reduces the variance of prices but with a corresponding loss in price informativeness. We also show that the sequence property of price‐contingent orders increases the probability of large price movements. This distinction between variance and episodic price volatility has important policy implications.

Information and the Cost of Capital

Published: 11/27/2005   |   DOI: 10.1111/j.1540-6261.2004.00672.x

David Easley, Maureen O'hara

We investigate the role of information in affecting a firm's cost of capital. We show that differences in the composition of information between public and private information affect the cost of capital, with investors demanding a higher return to hold stocks with greater private information. This higher return arises because informed investors are better able to shift their portfolio to incorporate new information, and uninformed investors are thus disadvantaged. In equilibrium, the quantity and quality of information affect asset prices. We show firms can influence their cost of capital by choosing features like accounting treatments, analyst coverage, and market microstructure.

PAPERS AND PROCEEDINGS SIXTY‐SECOND ANNUAL MEETING AMERICAN FINANCE ASSOCIATION

Published: 01/18/2016   |   DOI: 10.1111/j.1540-6261.2002.tb00681.x

Deposit Insurance and Wealth Effects: The Value of Being “Too Big to Fail”

Published: 12/01/1990   |   DOI: 10.1111/j.1540-6261.1990.tb03729.x

MAUREEN O'HARA, WAYNE SHAW

This paper investigates the effect on bank equity values of the Comptroller of the Currency's announcement that some banks were “too big to fail” and that for those banks total deposit insurance would be provided. Using an event study methodology, we find positive wealth effects accruing to TBTF banks, with corresponding negative effects accruing to non‐included banks. We demonstrate that the magnitude of these effects differed with bank solvency and size. We also show that the policy to which the market reacted was that suggested by the Wall Street Journal and not that actually intended by the Comptroller.

Primes and Scores: An Essay on Market Imperfections

Published: 12/01/1989   |   DOI: 10.1111/j.1540-6261.1989.tb02653.x

ROBERT A. JARROW, MAUREEN O'HARA

This paper investigates the reported relative mispricing of primes and scores to the underlying stock. Given transaction costs, we establish arbitrage‐based bounds on prime and score prices. We then develop a new nonparametric statistical technique to test whether prime and score prices violate these bounds. We find that prime and score prices do exceed stock prices, and often by a considerable amount. We demonstrate that this increased value is most likely due to the score's ability to save on the costs of dynamic hedging. We also show how short sale and trust size constraints impede the ability to arbitrage price disparities.

Is Information Risk a Determinant of Asset Returns?

Published: 12/17/2002   |   DOI: 10.1111/1540-6261.00493

David Easley, Soeren Hvidkjaer, Maureen O'Hara

We investigate the role of information‐based trading in affecting asset returns. We show in a rational expectation example how private information affects equilibrium asset returns. Using a market microstructure model, we derive a measure of the probability of information‐based trading, and we estimate this measure using data for individual NYSE‐listed stocks for 1983 to 1998. We then incorporate our estimates into a Fama and French (1992) asset‐pricing framework. Our main result is that information does affect asset prices. A difference of 10 percentage points in the probability of information‐based trading between two stocks leads to a difference in their expected returns of 2.5 percent per year.

Hidden Liquidity: Some New Light on Dark Trading

Published: 05/20/2015   |   DOI: 10.1111/jofi.12301

ROBERT BLOOMFIELD, MAUREEN O'HARA, GIDEON SAAR

Using a laboratory market, we investigate how the ability to hide orders affects traders’ strategies and market outcomes in a limit order book environment. We find that order strategies are greatly affected by allowing hidden liquidity, with traders substituting nondisplayed for displayed shares and changing the aggressiveness of their trading. As traders adapt their behavior to the different opacity regimes, however, most aggregate market outcomes (such as liquidity and informational efficiency) are not affected as much. We also find that opacity appears to increase the profits of informed traders but only when their private information is very valuable.

The Making of a Dealer Market: From Entry to Equilibrium in the Trading of Nasdaq Stocks

Published: 12/17/2002   |   DOI: 10.1111/1540-6261.00496

Katrina Ellis, Roni Michaely, Maureen O'Hara

This paper provides an analysis of the nature and evolution of a dealer market for Nasdaq stocks. Despite size differences in sample stocks, there is a surprising consistency to their trading. One dealer tends to dominate trading in a stock. Markets are concentrated and spreads are increasing in the volume and market share of the dominant dealer. Entry and exit are ubiquitous. Exiting dealers are those with very low profits and trading volume. Entering market makers fail to capture a meaningful share of trading or profits. Thus, free entry does little to improve the competitive nature of the market as entering dealers have little impact. We find, however, that for small stocks, the Nasdaq dealer market is being more competitive than the specialist market.

When the Underwriter Is the Market Maker: An Examination of Trading in the IPO Aftermarket

Published: 12/17/2002   |   DOI: 10.1111/0022-1082.00240

Katrina Ellis, Roni Michaely, Maureen O'Hara

This paper examines aftermarket trading of underwriters and unaffiliated market makers in the three‐month period after an IPO. We find that the lead underwriter is always the dominant market maker; he takes substantial inventory positions in the aftermarket trading, and co‐managers play a negligible role in aftermarket trading. The lead underwriter engages in stabilization activity for less successful IPOs, and uses the overallotment option to reduce his inventory risk. Compensation to the underwriter arises primarily from fees, but aftermarket trading does generate positive profits, which are positively related to the degree of underpricing.

What's Not There: Odd Lots and Market Data

Published: 06/25/2014   |   DOI: 10.1111/jofi.12185

MAUREEN O'HARA, CHEN YAO, MAO YE

We investigate odd‐lot trades in equity markets. Odd lots are increasingly used in algorithmic and high‐frequency trading, but are not reported to the consolidated tape or in databases such as TAQ. In our sample, the median number of odd‐lot trades is 24% but in some stocks odd lots are 60% or more of trading. Odd‐lot trades contribute 35% of price discovery, consistent with informed traders using odd lots to avoid detection. Omitting odd‐lot trades leads to inaccuracies in order imbalance measures and makes sentiment measures unreliable. Excluding odd lots from the consolidated tape raises important regulatory issues.

Market Statistics and Technical Analysis: The Role of Volume

Published: 03/01/1994   |   DOI: 10.1111/j.1540-6261.1994.tb04424.x

LAWRENCE BLUME, DAVID EASLEY, MAUREEN O'HARA

We investigate the informational role of volume and its applicability for technical analysis. We develop a new equilibrium model in which aggregate supply is fixed and traders receive signals with differing quality. We show that volume provides information on information quality that cannot be deduced from the price statistic. We show how volume, information precision, and price movements relate, and demonstrate how sequences of volume and prices can be informative. We also show that traders who use information contained in market statistics do better than traders who do not. Technical analysis thus arises as a natural component of the agents' learning process.

Option Volume and Stock Prices: Evidence on Where Informed Traders Trade

Published: 12/17/2002   |   DOI: 10.1111/0022-1082.194060

David Easley, Maureen O'Hara, P.S. Srinivas

This paper investigates the informational role of transactions volume in options markets. We develop an asymmetric information model in which informed traders may trade in option or equity markets. We show conditions under which informed traders trade options, and we investigate the implications of this for the linkage between markets. Our model predicts an important informational role for the volume of particular types of option trades. We empirically test our model's hypotheses with intraday option data. Our main empirical result is that negative and positive option volumes contain information about future stock prices.

Cream‐Skimming or Profit‐Sharing? The Curious Role of Purchased Order Flow

Published: 07/01/1996   |   DOI: 10.1111/j.1540-6261.1996.tb02708.x

DAVID EASLEY, NICHOLAS M. KIEFER, MAUREEN O'HARA

Purchased order flow refers to the practice of dealers or trading locales paying brokers for retail order flow. It is alleged that such agreements are used to “cream skim” uninformed liquidity trades, leaving the information‐based trades to established markets. We develop a test of this hypothesis, using a model of the stochastic process of trades. We then estimate the model for a sample of stocks known to be used in order purchase agreements that trade on the New York Stock Exchange (NYSE) and the Cincinnati Stock Exchange. Our main empirical result is that there is a significant difference in the information content of orders executed in New York and Cincinnati, and that this difference is consistant with cream‐skimming.

Liquidity, Information, and Infrequently Traded Stocks

Published: 09/01/1996   |   DOI: 10.1111/j.1540-6261.1996.tb04074.x

DAVID EASLEY, NICHOLAS M. KIEFER, MAUREEN O'HARA, JOSEPH B. PAPERMAN

This article investigates whether differences in information‐based trading can explain observed differences in spreads for active and infrequently traded stocks. Using a new empirical technique, we estimate the risk of information‐based trading for a sample of New York Stock Exchange (NYSE) listed stocks. We use the information in trade data to determine how frequently new information occurs, the composition of trading when it does, and the depth of the market for different volume‐decile stocks. Our most important empirical result is that the probability of information‐based trading is lower for high volume stocks. Using regressions, we provide evidence of the economic importance of information‐based trading on spreads.