2. History of Financial Markets Flashcards
What is bid price?
The highest price buyers are currently offering to pay for a security. It is the highest price you can sell your stock for immediately.
What is ask price?
The lowest price current sellers are willing to sell a security for. It is the lowest price you can buy a stock for immediately.
What is the bid-ask spread?
A bid-ask spread is the amount by which the ask price exceeds the bid price for an asset in the market. The bid-ask spread is the difference between the bid and ask price for an asset.
There is always an inherent gap between the lowest price traders are selling an asset for (ask price) and the highest price that traders are offering to buy securities for (bid price) as they have opposing interests. This inherent gap results in ask prices being greater than bid prices. The buyers want to pay as little as possible, and the sellers want to sell for as high as possible. To buy an asset, a buyer must pay the current ask price and to sell an asset, a seller must offer the current bid price and these prices almost always differ (creating a bid-ask spread).
The ask price is almost always greater than the bid price also because when the bid price is equal to or greater than the ask price, all matching asks and bids will execute trades until the bid price no longer exceeds the ask price. This process does not tend to last long and hence the equilbrium position tends to the one where ask prices exceed bid prices. If the bid price were ever higher than the ask price, this would create an arbitrage opportunity, as buyers could immediately purchase at the ask price and sell at the bid price for a profit. Such conditions quickly resolve as prices adjust through trading, leading to a natural equilibrium where the ask price exceeds the bid price.
When a website says a certain stock is £50, what it really means is that the current mid-point of the bid-ask spread is £50.
When do we describe a market as being ‘liquid’?
If there is regular buying and selling (high volume of trading activity/frequent transactions) and it is possible to trade without a large change in the market price.
If the transaction costs (e.g., bid-ask spread) are low.
What are the advantages of having a secondary market?
- Reduced transaction/trading costs (increased liquidity, easy price discovery, economies of scale)
- Buyers have a greater flexibility, they are not commited to hold until maturity. As instead, if they wish (and provided markets remain liquid) they can realise their investment by selling on to someone else at the going market price.
What is the efficient market hypothesis?
A hypothesis (formulated by Fama in 1970) in financial economics that states that asset prices reflect all available information. A direct implication is that it is impossible to “beat the market” consistently on a risk-adjusted basis, except through luck or chance, since market prices should only react to new information which is unpredictable in timing and impact (impact on asset price) and as the market reacts/adjusts instantly to new information.
What is a bubble? What is a crash?
A bubble is a period that is characterized by the rapid escalation of the market price of an asset beyond its true value. This fast inflation is followed by a sharp decrease in value, or a contraction, that is sometimes referred to as a “crash” or a “bubble burst.”
A bubble is created by a surge in asset prices which is usually driven by exuberant market behavior, where speculative demand pushes prices to unsustainable levels. During a bubble, assets often trade at prices that greatly exceed their fundamental value, with the price significantly misaligned from the asset’s intrinsic worth. The asset price created by a bubble is unsustainable because owners of the asset will often mass sell once they realise the asset is greatly overvalued.
What is the Gordon Growth model (variant of dividend discount model) for calculating share price and what does it imply?
It is a model that expresses a company’s share price as the present value of its future dividends, assuming those dividends grow at a constant rate.
It implies that a stock’s value RISES with increasing dividend value and that stock prices DECREASES with increasing inflation-adjusted interest rates, increasing equity risk premium or decreasing inflation-adjusted growth rate.
It is important to note that the rate of inflation does not directly impact stock prices in the Gordon growth model but in reality higher inflation may reduce equity prices due to it making investors and companies more risk averse, increasing equity risk premium and lowering dividend growth rates.
