Lecture 5 Flashcards
What is the effective spread?
The effective spread is the difference between the prices at which the dealers actually buy and sell.
Is the effective spread the same as the quoted bid-ask spread?
NO they can be different.
How do effective spreads arise?
- Traders trade with dealer at prices inside the quote.
2. Dealers adjust their quotes between trades.
Why do dealers adjust spreads between trades?
As they observe the market
In the dealer market, dealer will set their bid-ask spread to achieve what?
To maximize their profits
How big the dealers spreads are depends on what?
How much competition is in the market.
When the spread of a dealer is narrow this means the market is?
Competitive dealers are trying to encourage traders to trade with them.
When the spread of a dealer is wide this means the market is?
To make more profit and recover the costs of doing business.
What is adverse selection in financial trading?
occurs when one trader with special information uses that information to her advantage at the expense of her counter party in trade
Kyle (1985) theoretical model describes:
the trading behavior of informed traders and uniformed market makers in an environment with noise traders and liquidity traders.
What kind of auction model is Kyle’s:
one-single price auction model
Who is in this one-single price auction?
- Single Dealer
- Many uniformed traders
- Single informed trader with perfect information
The dealers price function is related to what in the market?
Supply and Demand
the dealers pricing function is related to the supply and demand and further the dealer’s perception of what?
the dealer’s perception of sensitivity of the intrinsic value to volume
what does the dealer’s perception of sensitivity of the intrinsic value to volume mean?
that as a dealer they can observe the order flow when their is an increase in supply or demand then I can see that something has changed with the fundamental value of the security
If the dealer thinks the market is sensitive that means:
That the dealer believes there are a lot of informed traders
If the dealer thinks the market is not sensitive that means:
That the dealer believes there are a lot of liquidity or noise traders and not many informed traders.
What are the implications of Kyle’s model for informed traders?
-if noise trader volume increases how will an informed trader trade:
-if the information that the informed trader has is significant how will the informed trader trade:
- I will trade in a higher volume
- if information is significant then the value of a stock will change a lot. The trader will not have to trade large quantities to maximize profit.
The dealer’s cost comes from 2 things:
- Cost of ignorance: informed traders know more.
2. Cost of carrying unbalance inventory:
What is negative serial correlation?
what you observe if dealer did not change their valuation idea and trade at the bid-ask across time then the prices themselves will have negative correlations.
What are a dealer’s transaction cost components:
- The dealer’s time
- Memberships, dues and data fees
- back office operations
- monopolistic rents
What determines the transaction costs?
- Trading Volume
2. Number of dealers and limit order traders
When do positive serial correlation in price changes?
Asymmetric information tends to produce positive serial correlation in price changes
In the information asymmetry model:
what is p?
probability that the next buyer is a well informed trader
In the information asymmetry model:
what is E?
dealer’s estimate of value of the error the dealer will have made if the next dealer is informed
If a buyer comes to a dealer and the dealer is unsure is buyer is informed or uniformed what is the probability:
(1-p)V + p(V+ E)
The ask price the dealer will charge (to sell a security) in information asymmetry model?
ask price= V + pE
If a seller comes to a dealer and the dealer is unsure is buyer is informed or uniformed what is the probability:
(1-p)V + p(V - E)
The bid price the dealer will charge ( to buy a security) in information asymmetry model?
bid price= V - pE
What is the bid ask spread given the probability formula in information asymmetry model?
(V + pE) - (V - pE)
=2pE
What does the information asymmetry model calculation tell us about how the dealer will set the price ?
that the dealer will set the price dependent on the probability of the informed traders in the market and the error amount they are likely to make
In the spread component what component should have no long run effect on price because it is unrelated to information?
Transaction Cost Component
In the spread component what component has a permanent effect on prices?
Price changes due to the adverse selection component have a permanent effect on prices as dealers infer values from the order flow.
Who supplies liquidity in a order driven market (2 people)?
- Patient Precommitted Traders
2. Value-Motivated Traders
Who are Patient Precommitted Traders, how do they trade, and what risks do they face?
- They are liquidity traders.
- Use limit orders to lower cost of trades they must make.
- Risk failing to trade when market moves away from their limit orders.
Who are Value-Motivated Traders, how do they trade, and their trading methods?
- Pre-committed traders who have meet their liquidity shock
- they provide depth at substantial cost (spread)
- they straddle if they think the value is $34 bid below $34 and ask above $34.
- ••
In an order driven market, each investor individually determines whether to (limit or market):
- Place a limit order and enable another investor to buy or sell by market order
- Submit a market order and enable another investor’s limit order to execute
- •••
What is the role of a investor who places a limit order in terms of liquidity?
•To provide liquidity
What is the role of a investor who places a market order in terms of liquidity?
•To take liquidity•••••
What is an event of news that affects all investors’ assessment of a security’s share value and is this good or bad for a liquidity trader?
Information Event
Bad; as the share price will move permanently away from limit order
What is an event that are unique to an individual trader and is this good or bad for a liquidity trader?
- Liquidity Event
- Good for liquidity traders as prices will drop and then slowly increase back giving the limit order a chance to be filled
