A Microstructure Perspective on the Effect of Uncertainty and Information Opacity on Equity Market Quality
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As Paulos (2003, para. 1) notes, “uncertainty is the only certainty there is, and knowing how to live with insecurity is the only security.” This statement cannot be more pertinent in the context of equity markets. Uncertainty makes it difficult to interpret information and can arguably hinder the efficient functioning of equity markets. The prevalence of uncertainty in equity markets emphasizes the need to thoroughly understand its impact on various aspects of equity markets. A good understanding of the impact of uncertainty is important not only for investors to fine-tune portfolio strategies but also for market regulators to maintain market quality. In that respect, this thesis is devoted to understanding the effect of information uncertainty on equity market quality. The empirical chapters of this thesis focus on the US equity market. Chapter 3 studies the effect of equity market uncertainty (EMUNC) on the informational efficiency of US equity prices. We consider the US equity market as a whole by focusing on exchange-traded funds (ETFs) and find that EMUNC significantly reduces ETFs’ price efficiency. This result indicates that uncertainty reduces the quality of the information environment and makes value-relevant signals noisy, which hinders the process of price discovery. Chapter 4 focuses on uncertainty about the Federal Open Market Committee (FOMC) announcement. These announcements represent informational shocks in the US equity market. Since investors anticipate these news announcements, they compete for trading profits using their private information about the forthcoming news. Thus, possessing accurate predictions about these news events should matter. Using analyst forecast dispersion to measure uncertainty about the impending FOMC news, we find that uncertainty significantly affects equity market quality during the FOMC announcement. In particular, uncertainty increases pre-announcement information asymmetry and reduces liquidity surrounding announcement times. Despite a reduction in liquidity, uncertainty leads to higher trading volume both before and after the announcement. Finally, we find that informational efficiency during the FOMC announcement deteriorates with higher analyst forecast disagreement. We also show that the effect of uncertainty is independent of and incremental to the effect of the FOMC announcement itself. Chapter 5 extends the first empirical chapter. In the first chapter, we find that EMUNC reduces the informational efficiency of ETF prices. In this chapter, we explore whether such an effect is cross-sectionally heterogeneous. We hypothesize and test two plausible channels that facilitate this cross-sectional heterogeneity: limits-to-arbitrage and uncertainty exposure channels. Using a sample of S&P 500 constituent stocks, we show that EMUNC has a stronger negative impact on stocks that are harder to arbitrage or have a higher past uncertainty exposure. Overall, this thesis enhances our understanding of uncertainty and its impact on equity market quality. The findings in empirical chapters are also potentially helpful for investors and market regulators for better investments and policy-making.