Toxic Arbitrage and Price Discovery

Toxic arbitrage opportunities are caused by information arriving in one market leading to short lived price deviations between markets. This paper shows that the direction of such arbitrage opportunities provides valuable insights into price discovery and markets’ information shares. Starting from a new theoretical framework of multi-venue trading, I derive an unbiased measure of information shares based on the frequency of toxic arbitrage opportunities. This measure has several advantages over traditional measures of price discovery, especially when looking at low liquidity environments, and provides a valuable addition in the analysis of price dynamics. I illustrate these advantages with a unique dataset for internationally traded foreign exchange futures.

Dead Cat Bounce - Demand reversal following the bursting of a bubble

This is the first paper to theoretically analyze the temporary reversal of the downward trend in financial assets, also known as dead cat bounce or bear market rally. We show that preferences according to cumulative prospect theory lead an investor to take ex- cessive risk and unprofitable positions in order to recover an initial loss in a declining market. The loss driven behavior results in premature re-entering into the market. We show that heterogeneous investors enter at the same time despite differences in the refer- ence point, wealth and initial loss. The resulting shift in aggregate demand can explain the sudden but temporary reversal common in declining financial markets.

The importance of employment risk for the effect of bonus taxation

Since the beginning of the financial crisis, it has been a common view that banker’s excessive risk-taking behaviour was at least partly responsible for the crisis. There have been multiple calls for reducing incentives of bankers to take risks and one proposed way is the taxation of bonus payments. Using a principal-agent model, Grossmann et al. (2011) find, however, that the introduction of a bonus tax may lead to more risk being taken. In contrast, this thesis argues that taking into account employment risk provides a mechanism which leads to risk-reducing effects of bonus taxation. Furthermore, this thesis shows that policy makers may face a trade-off between the financial markets’ efficiency and its stability.