Price discovery during anomalous market trading

… the Lehman Brothers case – Published on VOX, by Thomas Gehrig, May 25, 2016.

During normal operations, price discovery is an important feature of decentralised market trading. But the process can be distorted when markets are under great stress, such as during the run up to the collapse of Lehman Brothers in 2008. This column uses trading data from the days leading up to and following the collapse to show that price discovery at US stock exchanges remained remarkably efficient, even at the height of the turmoil.  

Price discovery is the hallmark of the benefits derived from decentralised trading in a market economy. When markets operate smoothly, the flow of information about traded goods or securities miraculously gets translated into prices reflecting this information almost instantly (Hayek 1945, Fama 1970). But how do markets perform in periods of ultimate stress? Does orderly price discovery still work? The final weeks prior to the Lehman Brothers’ failure, and the weeks after, present such a period of ultimate stress.

In joint work, my co-author and I analyse price discovery in US stock markets during this dramatic period, both in the Lehman’s stocks as well as in the stocks of its large US peers in commercial and investment banking (Gehrig and Haas 2016).

The Lehman insolvency: … //

… Price discovery for Lehman Brothers stock: … //
… Price discovery in the stocks of the largest US banks: … //

… Conclusion:

Overall, price discovery at US stock exchanges remained remarkably efficient even at the height of turmoil during the Great Recession. Even though there is no discernible leakage of information in pricing, there is clear evidence that a revaluation of the stock of Lehman Brothers did occur at least the very day before the public disclosure of what was going to be the final and lethal losses. Trading on 8 and 9 September is characterised by an extraordinary number of standard trades at constant spreads with little price impact individually, but with a clear aggregate impact and strong revaluation of the stock prior to the public disclosure. Price adjustments continue at high pace after the disclosure, but trade size increases while the number of trades recedes to even below normal levels.

(full text, 8 graphs, references, related links).


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