4 - Price Formation Process

Question 1

Trading

Answer 1

zero sum game where the total gains of the winners are exactly equal to the total loss of the losers

Question 2

Returns are positive for winners

Answer 2

comparative advantage

Question 3

Returns are negative for losers

Answer 3

get some benefit from trading

Question 4

Profit motivated

Answer 4

trade to make a profit

Question 5

Utilitarian

Answer 5

trade for other reasons

Question 6

Futile

Answer 6

trade to make profits but fail

Question 7

Investment and Divestment

Answer 7

• Individuals often need to manage their cash flow, moving money from one point in time to another
• Investors are uninformed traders who use the markets to obtain an unconditional rate of return
  
  • real risk free + risk premium
• Do NOT know fundamental value of asset

Question 8

Risk sharing

Answer 8

large projects are often too risky to be financed by individuals

• divide up projects among many owners to distribute risks
• pieces (shares and bonds) are marketed)

Question 9

Asset exchanges

Answer 9

traders use many markets to exchange one type of asset (usually money) for another that has some specific use
- e.g forex, spot commodities exchange

Question 10

Risk exchanging (hedging)

Answer 10

hedgers use financial markets to reduce their exposure to financial risk

Question 11

Gambling

Answer 11

securities markets allow people to take positions on uncertain future events, likely that some gamblers would also trade financial instruments

hope to make money but have no rational expectation to

Question 12

Tax reasons

Answer 12

• tax system provides opportunity for tax avoidance
• tax avoiders use market to minimize taxes paid
  
  • different in tax rates on dividends and capital gains/losses
  • deferral of taxable income

Question 13

Utilitarian traders look for

Answer 13

liquid markets with low transaction costs

Question 14

Speculators

Answer 14

informed traders who expect a conditional return

speculators collect, analyse, and produce information that is then used to predict future price changes

Question 15

Speculators differ by the information they use to forecast future price changes:

Answer 15

Informed traders: profit from knowing fundamental values

Parasitic traders (include order anticipators and bluffers)

• act on information about other traders’ orders
• create information to fool others

Question 16

Sentiment-oriented technical traders

Answer 16

predict trades that uninformed traders will decide to make

• trade ahead of uninformed traders
• profit when prediction is correct

Question 17

Squeezers monopolies one side of the market

Answer 17

• most common buying up supply thus controlling subsequent sales prices
• common in commodity markets

Question 18

Dealers:

Answer 18

profit motivated traders who profit by supplying liquidity to other traders who want to trade

• liquidity service they sell, immediacy, is valuable to impatient traders
• dealers often known as specialists or market-makers in stock exchanges and options exchanges

Question 19

Futile traders

Answer 19

noise traders

• trade on what they falsely believe to be special information
• if they trade in large numbers and if trading behavior is correlated, they may distort prices from fundamental value

Question 20

Informed traders

Answer 20

• fundamental value of a security is the expected NPV of all future benefits and costs associated with holding the security
  
  • value agreed upon if everyone knew every available piece of information

Question 21

Informed trading strategies

Answer 21

• profit motivates informed traders NOT desire to make prices more informative
• informed traders try to minimize their price impact to maximize their profits
  
  • trade aggressively to utilize informational advantage before it becomes public knowledge
  • trade slowly if they know information will not become public knowledge: stealth trading

Question 22

What is the effect of informed trading on price?

Answer 22

• trading by informed traders moves price towards the security’s fundamental value
• informed traders have different information, thus they form different estimates of value
  
  • market price is more informative than the single estimate from one informed trader

Question 23

Styles of informed trading

Answer 23

• value motivated traders
• headline traders
• information-orientated technical traders
• arbitrageurs

Question 24

Informed traders profit when they trade with uninformed traders

Answer 24

Actions of informed traders cause the markets to have informative prices

Question 25

Market efficiency

Answer 25

Prices are efficient with respect to a set of information if traders cannot profit from acquiring the information and trading on it

Question 26

At equilibrium cost of acquiring and trading on info =

Answer 26

revenue from info