Essays on liquidity in financial markets

The first essay investigates the effects of the introduction of index-tracking stocks for the Dow Jones Industrial Average and NASDAQ 100 on the liquidity of the underlying securities. There is evidence of increased liquidity. Specifically, quoted and effective spreads decrease. Also, the adverse selection component of effective spread decreases while the direct cost component remains unchanged. These findings are consistent with increased liquidity due to index arbitrage. Consistent with the diversification of firm-specific information in a composite security, the index-tracking stock has lower relative spread and adverse selection costs as compared to a price weighted composite of the underlying stocks. The second essay investigates the liquidity effects due to a stock's addition to the S&P 500. The addition of a stock to the index leads to an increase in the volume of liquidity-motivated trading. This lowers the cost of supplying liquidity and generates abnormal returns. Consistent with this argument, a permanent increase in the liquidity of stocks added to the S&P 500 index is observed. The improvement in liquidity is due primarily to a decrease in the direct cost of transacting and a smaller decline in the asymmetric information cost of transacting. Further, the event period abnormal returns are positively associated with the decrease in the direct cost of transacting. These findings support improved liquidity as a partial explanation for the observed wealth effect. The final essay analyzes the role of firm characteristics and ownership structure in determining the extent of adverse selection in securities markets. After controlling for the effects of the well-established determinants of adverse selection, a firm's ratio of plant, property, and equipment to total book assets, status as a public utility, and the number of financial institutions owning equity have additional explanatory power. To the extent these variables are reasonable proxies for the firm's opaqueness of assets, regulatory environment, and ownership structure, these factors are found to contribute to the adverse selection cost of transacting.