Ebook Understanding the Microstructure of Indian Markets
Market design is increasingly becoming a focal issue in the market microstructure literature. The primary reason for this interest is the fact that market design influences market conditions, which in turn impact the price formation process. In this study we propose to empirically document the market conditions-liquidity and informational environment that characterize how security markets in India function at the microstructure level. Our study will be based on the stocks listed on the National Stock Exchange (henceforth, NSE) of India which is a completely order driven electronic marketplace. The metric of our primary focus will be the bid-ask spread for a stock.
Bid-ask spread (the difference between the lowest ask price and highest bid price for a stock) represents the (variable) cost that an investor pays for a (round trip) trade. Thus, the magnitude of the spread is an important decision variable that an investor considers in choosing a trading venue, as well as the stocks to buy/sell. In classical economic theory, price formation is envisioned as an equilibrium process the outcome of which is an appropriate clearing price at which the demand from buyers equals the supply from sellers. Earlier models assumed a converging process where market frictions are non-existent or irrelevant.
Beginning with the work of Demsetz (1968), the existence of frictions in markets was recognized. There are costs of negotiation, both in terms of time and resources. There are search and bargaining costs. Incorporating these sources of friction in markets, two sets of equilibria were proposed: one for buyers, and one for sellers. Hence two sets of prices, the bid or buy price and the ask or offer price. In an exchange where one can get the bid and ask quotes separately and (price-quantity) orders arrive intermittently, the bid-ask spread depends upon a number of factors, including the probability of information based trading, the volume of trade, the pricing grid (tick size) and share price.
Researchers have, for a long time now, been interested in factors affecting the spread, viz., inventory cost, order processing cost, and adverse selection cost, and what role they play in influencing the demand for and supply of liquidity and on listing decisions. For example, other things being equal, if the order processing costs for a stock are higher in exchange A than on stock exchange B, then a firm would have an incentive to list in exchange B. Likewise, if an exchange mandates a higher tick size than a competing exchange for the same stock, it de-facto sets a floor on the stock’s spread. Thus, the trading platform and supervisory regime that an exchange offers impacts the bid ask spread for a stock. A lower bid ask spread implies higher liquidity for a firm’s stock. Studies have shown that firms with higher quality disclosures have lower effective bid-ask spreads and lower adverse selection spread components (Welker, 1995, Healy, Hutton, and Palepu, 1999). Ownership concentration of a firm impacts the spread of its stock (Attig, Gadhoum and Lang, 2003). Concentrated or pyramid shareholding has been shown to widen a stock’s bid ask spread.
Although it is hardly necessary to emphasize that the bid ask spread is arguably the most important metric that measures a stock’s or market’s liquidity, empirical evidence on spread has been established mostly in the context of the developed capital markets. To date, there has been little scientific work that presents a rigorous characterization of the market conditions, bid ask spread and price formation processes for the Indian stock markets, although India ranks second (after the United States) in terms of the number of stocks listed on its exchanges.
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