The Trading Strategy Of Investors Based On Liquidity

As an important attribution of the stock market, liquidity is where the vitality of the market lies. In a fully liquid market, assets and cash are interchangeable without any cost involved for the investors, which, as one of the most classic assumptions of traditional finance theories, has been greatly challenged in today's market where"abnormal phenomena"frequently occur. In the financial crisis that broke out in 1987, market liquidity almost dried up and the exchange channel of assets and currencies was totally disabled so that the investors experienced a drastic shrinkage of assets value. As the contrast between the book value of funds and their net return, a high book value did not necessarily correspond to a high net return, because the book value ignored the execution cost resulting from the impact of trades on price. The gap of reality and ideality makes the investors begin to bring liquidity into consideration and study the liquidity-based transaction strategy.Today when theories of value investment converge, the optimal control of the execution cost becomes one of the important weights for the institutional investors to gain competitive advantages. In an insufficiently liquid market, whether the influence of the institutional investors on price will impact the small investors'rights and benefits and whether the small investors'rights and benefits will be safeguarded, especially when considering the fast development of institutional investors and the diversity of the institutional investors, are critical questions deserving studies for the sake of a healthy and steady development of the stock market.In light of the fact that Chinese investors are mainly composed of the two kinds, from the perspective of the institutional investors, the present dissertation explores the following aspects:(1)It provides basis for the institutional investors to opt for liquid assets beforehand, by focusing on cost-based liquidity measurement indicators; (2)It gives the optimal readjusting strategy based on the invariable liquidity assumption during the trading period and analyses the impact of investors'risk-averse extent and the correlations between stocks on the optimal strategy; when investors are faced to trade in a day, the dissertation gives the optimal trading strategy for them considering the intraday liquidity pattern.(3)It deals with the game equilibrium among the institutional investors, when information of liquidation leaks out and is used by other institution investors.From the perspective of the small investors, the present dissertation investigates game equilibrium between the institutional investors and the small investors, and looks into the effect of the changes occurring to the constitution of the institutional investors on the small investors'rights and benefits through game analysis.By the above-mentioned studies, the present dissertation draws the following conclusions:(1)By regressing the Hasbrouck- Foster-Viswanathan (HFV) linear price impact model supported by the Stanzl's no-arbitrage theory (2004) on the high frequency transaction data of 68 stocks, the paper derives the price impact coefficient of each stock for each day and takes the coefficient as the liquidity index in an order-driven market.(2)On the assumption that trades have linear impact on the stock price, this paper gives the optimal readjusting strategy of portfolio. For a single stock, this paper gives the analytical solution and finds the proportion of immediate impact cost by trade and opportunity cost by holding is an important factor that influences the optimal strategy. When the opportunity cost by holding is more than the immediate impact cost by trade, investors will liquidate more intensively in the beginning, otherwise investors will trade more slowly. For a usual portfolio, this paper gives the computational solution. Through the sensitivity analysis of the optimal trading strategy to the investors'risk-averse extent, the paper finds the more risk-averse investors are, the more they care their risk exposure and the more they are inclined to liquidate all position in the beginning and buy the objective position in the end. Those who have more risk bearing capability are more inclined to make use of the correlations between stocks to decrease the portfolio readjustment cost.(3)Taking into account the intraday liquidity pattern, the paper presents for the trader, who is faced to buy a block till the next day, the optimal strategy for trading a large position, including how to break a block trade into smaller ones and when to submit an small order. Based on the U-shape intraday liquidity pattern of mature capital market and the pattern of Chinese stock market derived by empirical analysis, the paper shows the optimal strategy. By comparison analysis, we conclude the optimal strategy depends on the evolution of the market depth and the trading volume during the trading horizon. If the start-time of trades is different, the expected execution cost is different. If the mode of the intraday trading volume is invariable and level of the market depth is high, it is optimal to trade at market opening or market closing; if level of the market depth is low, it is optimal to trade during the noon. The comparison with the one-time trade shows that the execution cost of the strategy introduced here is much less.(4)By analysis of"predatory trading"between institution investors, this paper concludes that if the outstanding shares are approximate, the less institution investors are, the more intensely the predators compete and the more price decline caused by predatory trading and investors should care more about liquidity risk. It is preferable to keep the risk management sufficiently flexible by taking into consideration others'risk exposures and financial soundness. Through the investigation of the dynamic Cournot-Stackerberg game between institution investors and small investors, we conclude that institution investors make more profit than in the completely competitive economy because their desired order-flow moves price and the liquidity has relations with the distribution of risk bearing capacity among investors. We also can conclude that the more heterogeneous investors are, the more liquid the stock.The major innovation in this dissertation is:(1) On the assumption that trades have linear impact on the stock price, this paper gives the optimal readjusting strategy of portfolio. For a single stock, this paper gives the analytical solution and has an analysis of what effect the proportion of immediate impact cost by trade to opportunity cost by holding has on the optimal strategy. For a usual portfolio, this paper gives the computational solution and has deep analysis of the effect of correlations between stocks on the optimal strategy. Previous research has made many investigations on the optimal trading strategy of a single stock based on liquidity. Although they have extended their research from a single stock to a portfolio, the study is rough because of the math difficulty. This paper not only gives the analytical solution for a single stock but also has deep analysis on what effect the proportion of immediate impact cost by trade to opportunity cost by holding and waiting has on the optimal strategy. For a usual portfolio, this paper not only gives the computational solution but has deep analysis on the effect of correlations between stocks on the optimal strategy.(2)This paper has research on the optimal trading strategy for a single stock based on the intraday liquidity pattern and not only present for investors how to break a block order into small ones but also when to submit the small ones. Furthermore this paper has deep analysis on the optimal transaction time.Previous research on the optimal transaction strategy based on liquidity usually assumes liquidity is invariable during the transaction period. For the long-term readjustment object, because there is not strong empirical support that the inter-day liquidity pattern is significant, the above assumption is rational. However there is strong evidence that the intraday liquidity pattern is significant, so when investors are forced to trade in a day, they had better master the intra-day liquidity pattern and make use of it. If the intraday liquidity pattern exists, duration for processing the same order submitted on different time is not the same, and is correlated with the market liquidity.On the assumption of intraday liquidity pattern, this paper gives the optimal strategy of trading a large position, not only including how to break a block trade into smaller ones but when to submit an order.(3) This paper gives the two-period dynamic game equilibrium between small investors and institution investors on the assumption that investors are risk averse and rational. On assumption that investors are risk averse, this paper gives the two-period dynamic game equilibrium between small investors and institution investors. The equilibrium solution combines the subjective factor and objective one for asset pricing by introducing risk-averse extent. Through the analysis of equilibrium, we conclude that market liquidity has correlations with the distribution of risk bearing capability. The more dispersed risk bearing capability is, that is, the more heterogeneous investors are, the more liquid the market is. The conclusion presents a new angle for the measurement of liquidity. The institution investors could gain more in an imperfect competitive market than in a perfect one because of the price impact by trade, and the gain is correlated with the number of institution investors and the heterogeneity of investors.