Finance Cluster Seminar: Douglas Foster
Limit orders create risks from publicly observed price changes in related markets. We investigate how traders manage these risks by reviewing activity in National Australia Bank (NAB) shares and exchange-traded warrants over four 3-month intervals taken from 2001 through 2010. Two of these intervals correspond to key NAB corporate announcements and 2 of these intervals are related to trading technology upgrades. We develop a model where a costly monitoring and updating technology used by a warrant market maker results in informed traders concentrating their transactions in the underlying share market. In this setting the price adjustment model used by the warrant market maker is non-strategic and yields a “free option” empirical specification of the link between warrant market and share market quotes. We find evidence that warrant limit orders are updated quickly in response to changes in the underlying share price, consistent with both adverse selection and “free option” models of algorithmic limit order management. Inter-market links between limit orders include adjustments to both quoted depths and prices, and the intensity of these links are affected by trading rules and institutional specifications. Over the sample period we find that updating becomes more frequent and more consistent with our model.