Academic journal article IUP Journal of Applied Finance

The Pre-Open Call Auction Trading Mechanism and Its Efficiency: A Study on BSE Sensex Stocks

Academic journal article IUP Journal of Applied Finance

The Pre-Open Call Auction Trading Mechanism and Its Efficiency: A Study on BSE Sensex Stocks

Article excerpt

(ProQuest: ... denotes formulae omitted.)

Introduction

What determines the prices of securities in the financial market is of great importance to investors, companies, regulators and the market participants. A number of factors influence the prices of securities. Therefore, it is important to know the factors and the process of price discovery. Market regulators around the world have initiated a number of measures to ensure that the prices of financial securities reflect their intrinsic values. One of these measures is the changes in the market microstructure infrastructure. In India, Bombay Stock Exchange (BSE) and National Stock Exchange of India (NSE) have initiated some measures to improve the market microstructure. The BSE and NSE introduced opening Call Auction (CA) trading mechanism on BSE Sensex and NSE Nifty stocks on October 18, 2010. The introduction of Continuous Electronic Order System (CEOS) as trading mechanism for whole day was a major change from the open-outcry system of trading. The CEOS allows member traders to place an order and match the orders placed by other traders. In this system of trading, the impact of overnight information flow and the influence of foreign market movements were supposed to be reflected in the opening prices of Indian stock prices. To improve the price discovery in the market, the BSE introduced CA in place of CEOS in the opening session. The introduction of CA was mandatory based on the Securities and Exchange Board of India (SEBI) guidelines. In the second phase, on April 1, 2013, BSE had extended the CA process to all illiquid stocks listed on BSE based on the recommendations of the Secondary Market Advisory Committee (SMAC) and instructions of SEBI.

CA is also order-driven system that replaces the CEOS only for opening sessions consisting of 15 minutes from 9.00 a.m. to 9.15 a.m. The first 8 minutes are considered as the order collection period and the remaining period as the order matching period. CA allows traders (buyers and sellers) to place both limit and market orders in pre-open session of first 8 minutes. After completion of order collection period, the system uses the next 4 minutes to match and confirm the orders in a single price with consideration of maximum volume of stocks to be traded, and the last 3 minutes are used to buffer and transmit to CEOS. The implementation of CA is a major change in the market structure. The objective of CA is to increase the price efficiency in the opening session, minimize the opening price volatility and make prices reflect overnight information. Therefore, this policy measure is hypothesized to reduce price volatility and improve the price discovery. In this paper, we investigate whether the introduction of CA has improved the price discovery mechanism and has impacted the market friction. Since CA was initially introduced on the BSE Sensex stocks and BSE is the oldest stock exchange in Asia, there is a need to study how this has impacted the price discovery. Therefore, this study concentrates on the BSE Sensex stocks.

Literature Review

Exchanges upgrade their infrastructure to improve the efficiency and to become more user-friendly. The earlier researchers have contributed to existing literature by investigating the efficiency and effectiveness of change in market microstructure. Pagano and Roell (1996), Barclay et al. (1999), Chordia and Swaminathan (2000), Schultz (2000) and Schwartz et al. (2003) investigated the market microstructure and found that financial market structure influences efficient price discovery, liquidity, and transparency. They observed that stock exchanges are not uniform and they follow different kind of working nature. Therefore, the efficient price discovery and liquidity also differ from exchange to exchange. Huisman and Koedijk (1998) observed that trading mechanism's transparency influences the efficient price discovery and liquidity. Niemeyer and Sandas (1994) studied Stockholm Stock Exchange and its structure. …

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