Ch 5 Study Guide

Question 1

what are the components of trading costs?

Answer 1

brokerage cost
bid-ask spread
price impact
opportunity cost

Question 2

what are the three main components of trading costs that investors look for ?

Answer 2

bid-ask spread
price impact
opportunity cost

Question 3

This is the most explicit of the costs that any investor pays but it is usually the
smallest component

Answer 3

brokerage cost

Question 4

Today we have online platforms like Robinhood where it costs zero to trade,
but is it?

Answer 4

brokerage cost

Question 5

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 5

bid-ask spread

Question 6

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 6

price impact

Question 6

they believe that there is profit in trading,

Answer 6

active money managers

Question 7

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 7

opportunity cost

Question 8

who sets the bid-ask spread ?

Answer 8

the dealer or the market maker

Question 9

The average active money manager makes about

Answer 9

1% less than the market

Question 10

what three costs do the dealer face that are designed to cover the bid-ask spread ?

Answer 10

cost of holding inventory
cost of processing orders
cost of trading with informed investors

Question 11

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 ?

Answer 11

inventory rationale

Question 12

investors trading in an inventory rationale can be due to

Answer 12

information from informed traders
liquidity- liquidity traders
value traders

Question 13

In an inventory rationale, if the market makers sets the bid price too high

Answer 13

they will accumulate an inventory of
the stock

Question 14

in an inventory rationale, If the market makers set the ask price too low,

Answer 14

they will end up with a large short
position

Question 15

Market makers incur a ______ cost when executing orders, so the bid-ask spread has to cover these costs

Answer 15

processing cost

Question 16

These costs are likely to be small for large orders traded on the
exchanges

Answer 16

processing costs-bid ask spread

Question 16

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

Answer 16

processing costs

Question 16

These costs become larger for small orders of stocks that might be
traded only through a dealership market

Answer 16

processing costs

Question 16

technology has reduced these costs

Answer 16

processing costs

Question 17

The greater the differences in information possessed by different investors,

Answer 17

the more market maker has to worry about the magnitude of the impact

Question 17

This problem arises from the different reasons investors trade:
liquidity, information and views on valuation

Answer 17

adverse selection problem

Question 17

in an adverse selection problem, the spreads will be the function of what 3 factors?

Answer 17

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 18

Investors do not announce the reason for trading, so the market
maker runs the risk of trading against more informed investors.

Answer 18

adverse selection problem

Question 18

As the number of informed traders increases,

Answer 18

the bid-spread ask will increase

Question 19

The more uncertainty,

Answer 19

the greater risk, hence the higher bid – ask spread.

Question 19

what are the six factors determining the bid-ask spread ?

Answer 19

1. Liquidity
2. Ownership structure
3. Riskiness
4. Price Level
5. Information transparency & corporate governance
6. Market microstructure

Question 20

More liquid stocks have what effect on the bid-ask spread ?

Answer 20

lower bid ask spreads

Question 20

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

Answer 20

ownership structure

Question 21

riskier stocks tend to have what effect on the bid-ask spread ?

Answer 21

higher spreads

Question 22

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

Answer 22

price level

Question 23

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

Answer 23

Information transparency & corporate governance

Question 24

he 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 24

Market microstructure

Question 25

Strategies that involve investing in small - cap stocks or low-priced stocks
will be affected disproportionately by the costs created by bid – ask
spreads.

Answer 25

true

Question 26

why is there price impact ?

Answer 26

The first is that markets are not completely liquid and the second reason for the price impact is informational.

Question 27

what determines the role of investment strategies ?

Answer 27

type of stocks
need for speed
size of portfolio

Question 28

The price impact effect also will
come into play when a small portfolio manager tries to scale up the strategy.

Answer 28

size of portfolio

Question 29

the price of an asset that an
investor wants to buy because he or she believes that it is undervalued may rise
while the investor waits to trade, is an example of

Answer 29

a cost of waiting

Question 30

The more you trade, the
higher the tax liability you will face as an investor so you need to

Answer 30

keep trading at a minimum

Question 31

When investing, take into
account the expected tax drag on returns. Thus, if dividends are taxed at a rate higher than capital gains, you will pay more in taxes.

Answer 31

factor in taxes when buying

Question 32

When trading, consider
the tax effects of your trades. Match losing stock sales with capital gains.

Answer 32

factor in taxes when selling