Inducing liquidity in thin financial markets through combined-value trading mechanisms

Asset pricing theory hypothesizes that investors are only interested in portfolios; individual securities are evaluated only in terms of their contribution to portfolio risk and return. Yet, standard financial market design is that of parallel, unconnected markets, whereby investors cannot submit orders in one market conditional on events in others. When markets are thin, this exposes them to substantial execution risk. Fear of ending up with unbalanced portfolios after trading may even keep investors from submitting orders, further eroding liquidity and the ability of markets to equilibrate. The suggested solution is a portfolio trading mechanism referred to as combined-value trading (CVT). Investors are allowed to submit orders for packages of securities and the system matches trades and computes prices by optimally combining portfolio orders in an open book. We study the performance of the CVT mechanism experimentally and compare it to the performance of parallel, unconnected double auctions in experiments with similar parametrization and either a similar number of subjects or substantially thicker markets. We present evidence that our portfolio trading mechanism facilitates equilibration to the extent that the thicker markets do. Inspection of order submission and trade activity reveals that subjects manage to exploit the direct linkages between markets enabled by the CVT system. © 2002 Elsevier Science B.V. All rights reserved.

Published in:
European Economic Review, 46, 9, 1671-1695
California Institute of Technology, Division of Humanities and Social Sciences, 228-77 Caltech, Pasadena, CA 91125, United States Center for Economic Policy Research, 9098 Goswell Road, London EC1V 7RR, United Kingdom Hewlett Packard, 3000 Hanover Street, Palo Alto, CA 943041185, United States California Institute of Technology, Division of Humanities and Soc. Sc., 228-77, Caltech, Pasadena, CA 91125, United States
Cited By (since 1996): 10
Export Date: 10 March 2008
Source: Scopus
Other identifiers:
Scopus: 2-s2.0-0036773363

 Record created 2008-03-12, last modified 2018-03-17

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