Essays on price impact and provision of immediacy

This dissertation studies how the existence of transitory investors, i.e. investors who are only rarely present in the market, affects the market dynamics. With limited market participation order imbalance leads to a price impact and the following reversal on the stock price. Market makers and other immediacy suppliers synchronize the short-term supply and demand by increasing or decreasing their inventories, but they do this only if they can earn returns from providing immediacy. Their counterparties, immediacy demanders, suffer from costs of immediacy when they want to execute their trades immediately instead of waiting for arrival of other investors willing to trade. The first essay presents a structural model of the stock market with transitory investors. The essay studies the effects of various structural parameters on the stock’s liquidity, return reversal pattern, liquidity premium, volatility, the costs of immediacy to transitory investors, and market makers’ returns from providing immediacy. The results show that fast return reversal is typically a sign of inefficient, illiquid markets, thus not a sign of efficiency and that the stock’s liquidity premium and the cost of immediacy suffered by the infrequent investors are non-monotonic in several structural parameters of the model. The second essay presents a measure of the returns from providing immediacy by looking at the returns to a zero-investment contrarian long-short trading strategy utilizing short-term return reversals. These market makers’ returns also reflect a real cost of immediacy to other investors. The essay estimates mutual funds’ costs of immediacy and show that on average mutual funds suffer from costs of immediacy. The third essay studies whether hedge funds supply or demand immediacy using similar measure and finds that hedge funds typically supply immediacy in the stock market. The essay also shows that increases in the amount of speculative capital available to hedge funds improve market liquidity, reduce the amount of short-term return reversal and volatility consistent with immediacy provision. The fourth essay develops a model for the choice of the equity issuing method, where the major determinants of the choice are misvaluation of shares and the price impact from selling shares in the market. The price impact is larger for rights issues than for public offerings, as in the latter case the investment bank through its marketing efforts attracts new investors to the market reducing the price impact. Due to the difference in price impact public offerings dominate rights issues unless companies are sufficiently undervalued. The fifth essay studies the determinants of the daily executions of open-market repurchases. The essay finds that repurchase activity is higher when the markets for the stock are suffering from selling pressure, i.e. when predicted returns from providing immediacy are high, consistent with repurchases supplying immediacy in the stock market