High Frequency Trading and Volatility (Jonathan Brogaard, University of Washington)

October 4, 2011

KEYWORDS: High-Frequency Trading, Volatility

Authors:

Jonathan Brogaard, University of Washington - Department of Finance and Business Economics

Organizations:
  • University of Washington

Summary:

 

This paper investigates the relationship between high frequency trading (HFT) and volatility. One of the main concerns regarding the recent development of HFT is that it may exacerbate volatility and destabilize financial markets. The results of this paper show that HFT and volatility are intermingled. HFTrs’ activity changes as stock-specific volatility increases and the direction of the change varies significantly across liquidity providing activities and liquidity taking activities. Similarly, the results vary based on the time horizon of observation. To test for a statistically significant connection between HFT and volatility I implement a Granger causality test. There is strong evidence for HFT activity Granger causing volatility and for volatility Granger causing HFT activity. I use exogenous shocks to test for fundamental causality of volatility on HFT activity. By analyzing the HFT activity around news announcements, I find that, for stock specific news, volatility generally increases the extent to which HFTrs supply liquidity while decreasing the liquidity HFTrs take. The reverse is true for macro news. To study the reverse direction – the impact of HFT on volatility – I use the Short Sale Ban of 2008 as an exogenous shock to HFT activity and find that HFT decreases intraday volatility. This result generally holds in an alternative approach robustness check.


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