Ch 5 Study Guide Flashcards
what are the components of trading costs?
brokerage cost
bid-ask spread
price impact
opportunity cost
what are the three main components of trading costs that investors look for ?
bid-ask spread
price impact
opportunity cost
This is the most explicit of the costs that any investor pays but it is usually the
smallest component
brokerage cost
Today we have online platforms like Robinhood where it costs zero to trade,
but is it?
brokerage cost
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)
bid-ask spread
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
price impact
they believe that there is profit in trading,
active money managers
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.
opportunity cost
who sets the bid-ask spread ?
the dealer or the market maker
The average active money manager makes about
1% less than the market
what three costs do the dealer face that are designed to cover the bid-ask spread ?
cost of holding inventory
cost of processing orders
cost of trading with informed investors
Market makers have to quote bid and ask prices at which they are obligated to execute buy and sell orders from investors represents which category of the bid-ask spread ?
inventory rationale
investors trading in an inventory rationale can be due to
information from informed traders
liquidity- liquidity traders
value traders
In an inventory rationale, if the market makers sets the bid price too high
they will accumulate an inventory of
the stock
in an inventory rationale, If the market makers set the ask price too low,
they will end up with a large short
position
Market makers incur a ______ cost when executing orders, so the bid-ask spread has to cover these costs
processing cost
These costs are likely to be small for large orders traded on the
exchanges
processing costs-bid ask spread
Large proportion of these costs is fixed, as a result these costs as a
percentage of the price will be higher for lower priced stocks
processing costs
These costs become larger for small orders of stocks that might be
traded only through a dealership market
processing costs
technology has reduced these costs
processing costs
The greater the differences in information possessed by different investors,
the more market maker has to worry about the magnitude of the impact
This problem arises from the different reasons investors trade:
liquidity, information and views on valuation
adverse selection problem
in an adverse selection problem, the spreads will be the function of what 3 factors?
- The proportion of informed traders in an asset market.
- The differential information possessed on average by these
traders. - The uncertainty about future information on the asset.
Investors do not announce the reason for trading, so the market
maker runs the risk of trading against more informed investors.
adverse selection problem
