5 - Adverse selection, trading, and spreads

Question 1

Dealers

Answer 1

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

• dealers respond to demands for liquidity, passive traders

Question 2

bid-ask spread

Answer 2

spread between bid and offer

Question 3

quote sizes

Answer 3

sizes that they are willing to trade

Question 4

effective spread:

Answer 4

difference between the prices at which the dealers actually buy and sell

• traders trade with dealer at prices inside the quote
• dealers adjust their quotes between trades

Question 5

narrow spread

Answer 5

encourages others to trade with them

Question 6

wide spread

Answer 6

to recover costs of doing business

Question 7

adverse selection:

Answer 7

tendency of higher risk individuals to seek insurance coverage

Question 8

financial adverse selection

Answer 8

informed traders select profitable side of market to trade

Question 9

Lessons from Kyle’s (1985) model:

Answer 9

• if noise trader volume increases, informed trader’s trade volume INCREASES
• if information that informed trader has is significant, informed trader’s trade volume DECREASE

Question 10

Dealers’ costs come from:

Answer 10

• cost of ignorance
  
  • hit by better informed traders
• cost of carrying an unbalanced inventory

Question 11

If dealer only charges for transaction costs:

Answer 11

transaction prices will bounce between quoted bid and ask

Question 12

transaction cost component covers:

Answer 12

• dealers’ time
• memberships, dues and data feeds
• back office operations
• monopolistic rents

Question 13

determinants of transaction cost:

Answer 13

• trading volume

- number of dealers and limit order traders

Question 14

if dealers set spreads to cover only transaction costs, eventually will go out of business

Answer 14

• need to widen spread to cover their losses to informed traders
• adverse selection spread component

Question 15

Asymmetric information tends to:

Answer 15

produce positive serial correlation in price changes

Question 16

Best estimate of value is

Answer 16

(1-p) V + p ( V+E)

Ask price = V + pE

Bid price = V - pE

Bid-ask spread is 2pE

Question 17

transaction cost component should have __ long-run effect on price because it is unrelated to information

Answer 17

no

Question 18

Price changes due to adverse selection component have a _____ effect on prices as dealers infer values from the order flow

Answer 18

permanent

Question 19

Who supplies liquidity in an order driven market?

Answer 19

• Patient recommitted traders

- Value-motivated traders

Question 20

Take liquidity

Answer 20

submitting a market order and enabling another investor’s limit order to execute

Question 21

Information event

Answer 21

news that affects all investors’ assessment of a security’s share value

Question 22

liquidity event

Answer 22

events that are unique to an individual trader

Question 23

What must bid-ask spread be equal to have an indifference between limit and market orders?

Answer 23

Zero