Essays on investor behavior in financial markets and option pricing

Abstract

This thesis consists of three essays on investor behavior in financial markets and option pricing. The first essay provides an in-depth analysis of identified high frequency traders in the KOPSI200 futures market. Although high frequency traders’ order submission distribution across order aggressiveness is quite similar to other algorithmic traders and ordinary traders, 94 percent of non-marketable limit orders by high frequency traders are revised or cancelled and 74 percent of participation in trades is through marketable orders. I document that this highly impatient behavior is attributed to trading strategies that are based on extremely short-lived private information about future price movements, not passive market-making. Limit order revisions exhibit a tag-along effect; when the market moves away from (approaches) the original limit price, the revision price is set more (less) aggressively. Active use of fleeting orders by high frequency traders reduces the information content of the limit order book. The second essay presents a correction to a recently developed square root option pricing model. C^amara and Wang (2010) introduce a simple square root option pricing model where the square root of the stock price is governed by a normal distribution. They show that their three-parameter option pricing model can outperform the Black-Scholes option pricing model. I demonstrate that their assumption possesses an internal inconsistency in that the square root of the stock price can take on negative values. I revise and gen-eralize their assumption so that the internal inconsistency can be avoided, and introduce a new square root option pricing model. The difference in option prices calculated from the two models may not be trivial. The third essay proposes an econometric model to estimate time-varying hedge fund leverage using monthly return data only. Empirical tests on hedge fund indices and individual funds show that the model well describes time-variati...