Essays on Market Microstructure and Asset Pricing
Kyle, Albert S
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This dissertation contains two essays exploring the asset pricing implications of asymmetric information, hedging and market making. Chapter 1 studies position limits on strategic speculators in commodity futures. In this chapter I develop an equilibrium model with both spot and futures markets to evaluate the effects of speculative position limits proposed by commodity regulators. One of the main implications of this model is that the imperfectly competitive speculators can benefit from the limits at the expense of unconstrained market participants. Therefore, it is important to take into account the market competitiveness when setting position limits. I also find that the limits always reduce market liquidity and thereby increase the cost of hedging. Thus, position limits would benefit market makers but hurt hedgers. Moreover, the loss of liquidity due to the limits has a spillover effect on the spot market as futures prices reveal less information which makes all spot market participants worse off. Contrary to regulators' beliefs, the model suggests that an aggregate position limit may reduce speculators' competition and market liquidity even when the limit does not bind. The model provides an alternative explanation of magnet effect of position limits, which is imperfect competitive speculators tend to exert their market power to make the limits bind. Chapter 2 (joint with Yajun Wang) studies dynamic of market making and asset pricing. In this chapter, we develop a dynamic model of market making with asymmetric information where imperfectly competitive market makers match offsetting trades and carry zero inventory over time. Our model captures key features of market making in many financial markets: market makers optimally facilitate trading in both bid and ask markets by adjusting bid and ask prices and they hold close-to-zero inventories at the end of the day. We solve for equilibrium bid/ask prices and market depths in closed-form, and examine how informed traders dynamically hedge liquidity shocks and reveal private information. We further study the dynamics of bid-ask spread and trading volume to understand how these may interact with each other in shaping asset prices and market liquidity.