Lecture Four Flashcards
Trading
zero sum game where the total gains of the winners are exactly equal to the total loss of the losers
Returns are positive for winners
comparative advantage
Returns are negative for losers
get some benefit from trading
Profit motivated
trade to make a profit
Utilitarian
trade for other reasons
Futile
trade to make profits but fail
Investment and Divestment
- Individuals often need to manage their cash flow, moving money from one point in time to another
- Investors are uninformed traders who use the markets to obtain an unconditional rate of return
- real risk free + risk premium
- Do NOT know fundamental value of asset
Risk sharing
large projects are often too risky to be financed by individuals
- divide up projects among many owners to distribute risks
- pieces (shares and bonds) are marketed)
Asset exchanges
traders use many markets to exchange one type of asset (usually money) for another that has some specific use
- e.g forex, spot commodities exchange
Risk exchanging (hedging)
hedgers use financial markets to reduce their exposure to financial risk
Gambling
securities markets allow people to take positions on uncertain future events, likely that some gamblers would also trade financial instruments
hope to make money but have no rational expectation to
Tax reasons
- tax system provides opportunity for tax avoidance
- tax avoiders use market to minimize taxes paid
- different in tax rates on dividends and capital gains/losses
- deferral of taxable income
Utilitarian traders look for
liquid markets with low transaction costs
Speculators
informed traders who expect a conditional return
speculators collect, analyse, and produce information that is then used to predict future price changes
Speculators differ by the information they use to forecast future price changes:
Informed traders: profit from knowing fundamental values
Parasitic traders (include order anticipators and bluffers)
- act on information about other traders’ orders
- create information to fool others
Sentiment-oriented technical traders
predict trades that uninformed traders will decide to make
- trade ahead of uninformed traders
- profit when prediction is correct
Squeezers monopolies one side of the market
- most common buying up supply thus controlling subsequent sales prices
- common in commodity markets
Dealers:
profit motivated traders who profit by supplying liquidity to other traders who want to trade
- liquidity service they sell, immediacy, is valuable to impatient traders
- dealers often known as specialists or market-makers in stock exchanges and options exchanges
Futile traders
noise traders
- trade on what they falsely believe to be special information
- if they trade in large numbers and if trading behavior is correlated, they may distort prices from fundamental value
Informed traders
- fundamental value of a security is the expected NPV of all future benefits and costs associated with holding the security
- value agreed upon if everyone knew every available piece of information
Informed trading strategies
- profit motivates informed traders NOT desire to make prices more informative
- informed traders try to minimize their price impact to maximize their profits
- trade aggressively to utilize informational advantage before it becomes public knowledge
- trade slowly if they know information will not become public knowledge: stealth trading
What is the effect of informed trading on price?
- trading by informed traders moves price towards the security’s fundamental value
- informed traders have different information, thus they form different estimates of value
- market price is more informative than the single estimate from one informed trader
Styles of informed trading
- value motivated traders
- headline traders
- information-orientated technical traders
- arbitrageurs
Informed traders profit when they trade with uninformed traders
Actions of informed traders cause the markets to have informative prices
Market efficiency
Prices are efficient with respect to a set of information if traders cannot profit from acquiring the information and trading on it
At equilibrium cost of acquiring and trading on info =
revenue from information
Dealers and bid-ask spread
dealers are profit motivated who supply liquidity to other traders (passive traders)
- respond to demands for liquidity
- quote prices which they are willing to buy and sell
Dealer Quotes
Sizes they are willing to trade
Quoted bid-ask spread can be different from inside spread and different from effective spread
Effective Spread
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
narrow spread
encourages others to trade with them
wide spread
recover costs of doing business
adverse selection:
tendency of higher risk individuals to seek insurance coverage
non-diversifiable risk
financial adverse selection
informed traders select profitable side of market to trade
Lessons from Kyle’s (1985) model:
- 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
Dealers’ costs come from:
- cost of ignorance
- hit by better informed traders
- cost of carrying an unbalanced inventory
If dealer only charges for transaction costs:
transaction prices will bounce between quoted bid and ask
Negative serial correlation in price changes
transaction cost component covers:
- dealers’ time
- memberships, dues and data feeds
- back office operations
- monopolistic rents
determinants of transaction cost:
- trading volume
- number of dealers and limit order traders
if dealers set spreads to cover only transaction costs, eventually will go out of business
- need to widen spread to cover their losses to informed traders
- adverse selection spread component
Asymmetric information tends to:
produce positive serial correlation in price changes
Best estimate of value is
(1-q) V + q ( V+E)
Ask price = V + qE
Bid price = V - qE
Bid-ask spread is 2qE
transaction cost component should have __ long-run effect on price because it is unrelated to information
no
Price changes due to adverse selection component have a _____ effect on prices as dealers infer values from the order flow
permanent
Who supplies liquidity in an order driven market?
Designated Market Makers
- Patient precommitted traders
- Value-motivated traders
Take liquidity
submitting a market order and enabling another investor’s limit order to execute
Information event
news that affects all investors’ assessment of a security’s share value
liquidity event
events that are unique to the individual trader
What must bid-ask spread be equal to have an indifference between limit and market orders?
zero
Designated Market Makers
firms that offer trading services
obligations: maintain maket liquidity for certain stocks
May get the benefit of monetary incentives i.e. declining fee schedule
Limit Order Market
- limit order traders (LOT) will lose if only an information event occurs
- arrival of liquidity motivated traders creates a profit opportunity for LOT
Each investor determines whether to:
- take liquidity: take a market order and enable another investors limit order to execute
- provide liquidity: place a limit order and enable another investor to buy or sell via market order
