Ch 5

Question 1

This is the most explicit of the costs that any investor pays but it is usually the
smallest component. Today we have online platforms like Robinhood where it costs zero to trade, but is it?

Answer 1

brokerage cost

Question 2

The spread between the price at which you can buy an asset (the dealer’s ask
price) and the price at which you can sell the same asset at the same point in time (the dealer’s bid price)

Answer 2

bid-ask spread

Question 3

The price impact that an investor can create by trading on an asset, pushing the price
up when buying the asset and pushing it down while selling.

Answer 3

price impact

Question 4

There is the opportunity cost associated with waiting to trade. While being a
patent trader may reduce the previous two components of trading cost, the waiting can cost profits both on trades that are made and in terms of trades that would have been profitable if made instantaneously but which became unprofitable as a result of the waiting.

Answer 4

opportunity cost

Question 5

why does active money managers trade ?

Answer 5

they believe that there is profit in trading, and the return to any active money manager has three ingredients to it:

– Return on active money manager = Expected ReturnRisk + Return from active trading ‐‐‐Trading costs

Question 6

how much does the average money making make ?

Answer 6

about 1% less than the market

Question 7

in the value line experience, money managers

Answer 7

either underestimate trading costs or overestimate the returns of active trading or Both

Question 8

who sets the bid-ask spread in most markets ?

Answer 8

the dealer or market maker

Question 9

what are the three costs that the dealer faces that the spread is designed to cover ?

Answer 9

1. cost of holding inventory
2. cost of processing orders
3. cost of trading with informed investors

Question 10

according to the three costs the dealer faces, do the spread have to be large enough to cover while yielding a reasonable profit to the market marker on his/her investment ?

Answer 10

yes because those three costs are designed to ensure that the spread covers it

Question 11

these investors could be trading because of what ?

Answer 11

1. information from informed traders
2. liquidity (liquidity traders)
3. value traders

Question 12

who have to quote bid and ask prices at which they are obligated to execute buy and sell orders from investors ?

Answer 12

market makers

Question 13

they may have inventory constraints from the
exchanges, regulatory agencies, capital limitations or risk.

Answer 13

market makers

Question 14

If the market makers sets the bid price too high, they will accumulate an
inventory of the stock – why?

Question 15

If the market makers set the ask price too low, they will end up with a large
short position – why

Question 16

In both cases, there is a cost to the market makers that they will attempt to
recover by increasing the bid – ask spread

Answer 16

this is if they set the bid price too high and setting the ask price too low

Question 17

Market makers incur a processing cost when executing orders, so the

Answer 17

bid-ask spread has to cover these costs

Question 19

processing costs are likely to be

Answer 19

small for large orders traded on the exchanges

Question 20

when processing costs become larger for small orders of stocks

Answer 20

they might be traded only through a dealership

Question 21

when a large proportion of processing costs is fixed,

Answer 21

as a result, these costs as a percentage of the price will be higher for lower priced stocks

Question 22

what has reduced processing costs

Answer 22

technology

Question 23

when investors don’t announce their reasons for trading,

Answer 23

the market maker runs the risk of trading against more informed investors

Question 24

the adverse selection problem arises from

Answer 24

the different reasons investors trade

Question 25

when investors don’t announce the reason for trading, the spreads will be a function of what three factors?

Answer 25

1. the proportion of informed traders in an asset market
2. the differential information possessed on average by these traders
3. the uncertainty about future information on the asset

Question 26

As the number of informed traders increases, the bid‐ask spread will increase is a result of what factor ?

Answer 26

proportion of informed trader in an asset market

Question 27

The greater the differences in information possessed by different investors, the more market maker has to worry about
the magnitude of the impact is a result of what factor ?

Answer 27

differential information possessed on average by these traders.

Question 28

The more uncertainty, the greater risk, hence the higher bid – ask spread is a result of what factor

Answer 28

The uncertainty about future information on the asset.

Question 29

what are the 6 factors of determining the bid-ask spread

Answer 29

1. liquidity
2. ownership structure
3. riskiness
4. price level
5. information transparency and corporate governance
6. market microstructure

Question 30

More liquid stocks have lower bid – ask spreads.

Answer 30

liquidity

Question 31

Stocks with increases in institutional activity report higher
bid – ask spreads (perhaps because institutional investors tend to be more likely
to be informed?)

Answer 31

ownership structure

Question 32

Riskier stocks tend to have higher bid‐‐‐askspreads

Answer 32

riskiness

Question 33

The spread as a percent of the price increases as price levels decrease

Answer 33

price level

Question 34

Bid – ask spreads tend to
increase as information becomes less transparent and as corporate governance
gets weaker

Answer 34

Information transparency & corporate governance

Question 35

The exchange on which an asset is traded can affect bid – ask spreads as does the mode of trading: electronic versus floor trading, for
instance.

Answer 35

market microstructure

Question 36

Lower priced stocks in the U.S have substantially higher spreads (as a percent of stock price) than higher priced stocks reflects

Answer 36

the price level

Question 37

he stocks in the top 20% in terms of trading volume had an average spread of only 0.62% of the price while the stocks in the bottom 20% had a spread of 2.06% reflects

Answer 37

the trading volume

Question 38

As insider holdings increase, as
a percent of total stock outstanding, bid ask spreads increase, reflecting lower liquidity (since insiders don’t trade their holdings as frequently) and a fear that insiders may know more about the company than other investors (information asymmetry) reflects,

Answer 38

ownership structure

Question 40

spread/ price