Transaction costs liquidity and expected returns at the

Transaction costs, liquidity and expected returns at the Berlin Stock Exchange, 1892 -1913 Carsten Burhop, Universität zu Köln Sergey Gelman, ICEF, Higher School of Economics, Moscow 1 st ILFE Workshop, Moscow, September 18, 2010

Motivation Explore effective transaction cost determinants & effects in a ‘friendly environment’: on an early call auction stock market over a long time span 2

Outline 1. 2. 3. 4. 5. Literature review Historical background Data & Methodology Results Conclusion 3

1. Literature Review I: liquidity & asset pricing • Amihud (2002, JFM) – Positive risk premium for expected illiquidity – Inverse relation of returns and unexpected illiquidity shocks • Eleswarapu/Reinganum (1993), Brennan and Subrahmanyam (1996) – Negative/insignificant risk premia • Bekaert et al. (2007, RFS) – Dynamic interdependence of liquidity and returns on the market level (whereby liquidity only weakly dependent); – Transaction cost adjustment + liquidity risk premium • Goyenko et al. (2009, JFE) – Effective transaction cost measures capture liquidity (incl. price impact) 4

1. Literature Review I: economic history • Rajan & Zingales (2003): German pre-1913 stock market development higher than US • Baltzer (2006): price differentials across stock exchanges negligible • Gelman & Burhop (2008) – weak information efficiency on a rather high level – Efficiency worsens during crises 1901, 1913 • Gehrig & Fohlin (2006) – estimate effective transaction costs for Berlin stock exchange in 1880, 1890, 1900, 1910. Find gradual decline. – find inverse relationship to size 5

1. Contribution • Transaction costs were on average low, but rather variable in time and crosssection • Transaction costs are inversely influenced by size and previous year returns; are higher in crises • There is a significant positive liquidity premium, which is more pronounced than market risk and size premia 6

2. Historical background I • Berlin Stock Exchange (BSE) was the major German stock exchange since 1870 -s • Steadily increasing # of traded companies, around 1000 in 1913 • Trading 6 days per week, one price per day • Call-auction mechanism with a specialist • Presence of informed insiders possible 7

Berlin Stock market performance Leipziger Bank defaults Bank run in US Balkan war 8

German aggregate stock trading volume (in bln mark) 9

2. Historical background II • Major crises with impact on efficiency: – Bankruptcy of Leipziger Bank 1901 – Balkan war fear 1913 • Fixed relative transaction costs: – Transaction tax: 0. 01% up to 04/1894; 0. 02% to 10/1900 and 0. 03% until the end of the sample – Broker fee: official 0. 05%; private 0. 025% – Provisions for intermediaries: 0. 1 -0. 33% – Total round-trip transaction cost: 0. 252 -0. 82% – Tick size 0. 05 Mark (by stock prices of 40 Mark and above) less than 0. 125% 10

3. Data • Daily stock prices for 27 stocks (hand-collected from Berliner Börsenzeitung) 1892 -1913, 6692 observations per company – Industries: banking, machinery, chemicals, mining, textile, etc. – Requirement: listed during the whole period, <30% zero returns • Trading volume is available only on annual basis aggregated for all German exchanges! • Daily stock index values (from Gelman/Burhop 2008) • Annual values for market capitalization – Heterogeneous: from 0. 3 bln RM to 32. 8 bln RM • Dividend amounts and dates 11

Descriptive statistics (selection) 12

3. Methodology I • Measure of full transaction costs (fixed costs + price impact): – LOT (1999): information-based measure 13

3. Methodology I • Estimate with MLE 14

3. Methodology I • Criticism of LOT measure – Zero returns may be due to noise trading – The measure is driven by the market return volatility – Does not incorporate other factors than market • Justification – Is the only available measure of the full transaction costs and not only spreads – Widely used in recent financial literature, e. g. Griffin et al. (2010, RFS); Lesmond (2005, JFE) 15

3. Methodology II: Determinants • Cross-section and Panel estimation • Dependent variable: annual effective TC (LOT measure) of a company • Regressors: – Market cap (for size) – Previous year returns – Aggregate trading volume or Time dummies 16

3. Methodology III: impact on asset pricing • Fama-Mac. Beth(1973) regression – monthly returns – factor loadings & firm characteristics • Factor: market risk (our index as proxy) • Characteristics: – Size – Daily return autocorrelation (momentum) – LOT transaction cost measure (for illiquidity) 17

4. Results: annual transaction costs 18

4. Results: annual transaction costs 19

4. Transaction costs BSE 18921913: rolling window 20

4. Results: time series of transaction costs • Transaction costs are low: average LOTmeasure of 0. 97%, – lower than for the upper decile of NYSE (1. 23%) in 1963 -1990 (Lesmond et al. 1999) – better than any of the emerging stock markets in 1990 -s (Lesmond 2005) – But a bit above than DJIA costs of 0. 6% 19701980 (Goyenko et al. 2009) • High variation: from 0. 66% (1906) to 1. 68% (1901) 21

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4. Determinants of transaction costs: Cross-sectional results ln(MCap) 23

4. Determinants of transaction costs: panel 24

4. Determinants of transaction costs: panel 25

4. Determinants of transaction costs: results • Inverse relation with size – explains about 2/3 of transaction cost variation in cross-section and 23% in a panel set-up – One std increase in share of m. cap. (0. 05) leads to 0. 125 -0. 2 decrease in transaction costs – significance vanishes in FE set-up if we include past returns • Inverse relationship with previous year returns explains about 10% – One std decrease in past returns (0. 126) leads to apprx 0. 05 increase in LOT 26

4. Determinants of transaction costs: results • Transaction costs are about 0. 25 percentage points higher in crises years • Transaction costs are inversely related to trade volume – One std increase in log trading volume (0. 25) induces 0. 05 decrease in transaction costs 27

4. Effects of transaction costs on asset pricing 28

4. Asset pricing results • We find support of Amihud (2002): – Lagged transaction costs increase expected return – Contemporaneous TC – decrease returns • CAPM doesn’t work • Size effect is absorbed by ex-ante transaction cost measure • Momentum is positive with tendency to significance 29

4. Asset pricing results • Different specifications of liquidity risk do not yield significant results 30

5. Conclusion • Transaction costs of the Berlin Stock Exchange were on average rather low as early as 1892 -1913 • Size and past returns were negatively and crises were positively related to transaction costs • Illiquidity was the primary concern of investors by asset pricing, levied a positive premium 31

Thank you for your attention 32