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FINA3307 > Lecture Three > Flashcards

Lecture Three Flashcards

1
Q

Quote driven markets vs order driven markets

A

In pure quote driven markets, public traders cannot arrange trades among themselves

In order driven auction market, all traders issue orders to the exchange

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2
Q

NYSE

A
  • Largest stock exchange in world
  • Prior to 2006, most trades conducted on floor by trading crowd
  • One specialist for each stock
  • Affirmative obligations to offer liquidity: traders of last resort
  • Negative obligations: yield to public orders

Specialists maintained a book containing all unexecuted securities, has significant trading advantages relative to other market participants

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3
Q

House Broker (Commission brokers)

A
  • Represent brokerage houses and deal with public and handle orders off the floor
  • Nowadays handle large and complex executions needed by institutional customers
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4
Q

Independent Brokers

A

Known as $2 brokers or broker’s broker

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5
Q

Floor traders (Competitive Traders)

A

They trade in stocks on the floor for an account in which there is an interest

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6
Q

2006 NYSE was demutalised and merged with Archipelago: role of specialist passed on to designated market makers (DMMs)

A

DMMs no longer possess trading advantages as they have no special access to order books

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7
Q

SuperDOT trading system is replaced by NYSE super display book system (SDBK) for routing and processing orders

A

Customers able to execute orders in as quickly as 5 milliseconds

No longer needed to present orders at trading post by a commission broker

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8
Q

Floor trading has diminished significantly since the merger

A

DMMs have been involved in less than 1 in 30 transactions

- 1 in 7 in 2002

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9
Q

Alternative Trading Systems (ATS)

A

Trading venue that is not registered with SEC as an exchange

It centralizes, crosses, matches and executes trading interest
- Provides electronic forums for linking dealers with each other and with institutional investors

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10
Q

Types of ATS

A
  • Electronic communication networks (ECNs)
  • E.g instinet, archipelago
  • Dark pools and “crossing networks”
  • Internalization crossing networks
  • voice-brokered third party matching
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11
Q

Trading on ASX

A

Centralized limit order book

No DMMs, no specialists

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12
Q

Liquidity:

A

Refers to an asset’s ability to be easily purchased or sold without causing significant change in the price of an asset
- Assets can be easily traded with low transactions costs at any time with little impact on the asset’s price

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13
Q

Black (1971) liquidity:

A
  • Always bid and asked prices for the investor who wants to buy or sell small amount of stock immediately, spread is small
  • Investor who buy or sell large amount of stock, in absence of special information, can do so over long period of time at a price not very different from current price
  • Investor can buy or sell large blocks of stock immediately but at a premium or discount that depends on size of the block
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14
Q

A market is liquid if:

A

uninformed traders can quickly buy or sell large size when they want at a low transaction cost

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15
Q

Kyle (1985) liquidity dimensions:

A
  • Width: the size available at a given cost
  • Depth: time that passes before traders recognize uninformed traders have caused prices to change
  • Resiliency: cost per unit
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16
Q

Institutional investors:

A

mutual funds, pension funds, life insurance companies, trust departments of banks & investment companies

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17
Q

Institutional transactions

A

are executed by professional traders in the institutions or acting as their agents
- execution of orders likely impacts price

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18
Q

Investment companies

A

manage assets on behalf of clients

- assets include publicly traded financial securities

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19
Q

Closed-end investment company

A

corporation that issues a specified number of shares that can be traded on the exchange

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20
Q

Open-end investment company

A

accept additional funds and repurchase shares directly from investments

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21
Q

Exchange traded funds

A

shares are traded on exchange but differ from closed-end investment companies

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22
Q

Pension funds

A

Established by US employers to facilitate and organize the investment of employee’s retirement funds

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23
Q

Private equity

A

asset managers who make equity investment in companies that are not publicly traded

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24
Q

Hedge funds

A

unregistered private funds that allow investors to pool their investment assets
-invest in assets where other institutions are prohibited, e.g securities of distressed companies, conduct short sales and derivative to profit from market downturns and arbitrages

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25
Q

1994, institutional trading accounted for 75-80% of NYSE volume

A

Institutional orders are large

-about 80% of US institutional orders exceed half of relevant stocks average daily trading volume

26
Q

Common for institutions to break their order into smaller tranches spread over extended period of time

A
  • slice and dice
  • risk being front run
  • missed opportunity cost
27
Q

Iceberg orders

A

only a small part of an order is shown in limit order book, larger part is hidden
- as executions are realized, successive part of the order are entered in the limit order book

28
Q

Minimise trading costs by

A

revealing minimal information about their trading intentions to the market
- institutions want anonymity but want to see orders of everyone else

29
Q

Algorithmic trading

A

refers to automated trading with the use of live market data and rule-driven computer programs

  • for automatically submitting and allocating trade orders among markets and brokers
  • as well as over time so as to minimize price impact of large trades
30
Q

Many institutional traders use algo trading to:

A

reduce execution risk, preserve anonymity, and to minimize trade slippage

31
Q

Trade slippage

A

=market impact of trade
- Pt+k - Pt

Relation between trade slippage and transaction size is likely to be non linear

32
Q

Stealth trading

A

where privately informed traders fragment their large order, routing them to different markets at different times to disguise their intentions

33
Q

Large vs med vs small

A
  • large trades will reveal information
  • small trades will incur excessive transaction costs
  • medium trades will be used by informed traders
34
Q

Study by Campbell et al. in 2009 found:

A
  • institutions use larger and smaller transactions
  • institutions prefer small and medium transactions when trading on high volume days, large transactions on high volatility days
35
Q

Sunshine trading

A

traders announce their intentions

  • attempt to attract more liquidity providers to the market
  • if trades are not informationally driven, may get better prices than stealth trading
36
Q

2011 scenario when US govt announced plan to sell bank shares accumulated during 2008 crisis

A

market fully aware

minimal negative impact on share prices

37
Q

Dark pools

A

do not post quotes or transaction prices

-function in parallel with traditional markets

38
Q

Types of dark pools

A

1) Public crossing networks: cross buy and sell orders at the spread mid-point (derivative pricing rule)
2) internalisation pools: broker provides both buy and sell flow from its own proprietary desks and its customers

39
Q

Volatility

A

share prices fluctuate with market uncertainty and also illiquidity in the market

40
Q

What are the institutional trading needs?

A
  • Consolidation of order flow
  • consolidation refers to the pooling of order flow in one market center

This increases order interaction, concentrates liquidity, and improves accuracy of price discovery

Fragmentation both spatial and temporal due to the slice and dice
- increases intraday price volatility

41
Q

Chan and Lakonishok 1993 and 2001 suggest buy orders are more informationally driven

A
  • liquidity needs drive many sales
  • much larger pool of stocks from which to buy than to sell
  • restrictions on short selling: focus is on shares that the institution might buy
  • funds cannot borrow to invest, must be selective with their purchases
42
Q

National Best Bid

A

highest bid at any given time

43
Q

National Best Offer

A

lowest ask price at any given time

44
Q

Utilitarian Traders

A

trade because they expect to obtain some benefit from trading other than profit

45
Q

Utilitarian Traders: Risk Sharing

A

large projects are too risky to be financed by individuals

- divide projects up amongst many owners to distribute risk

46
Q

Utilitarian Traders: Asset Exchanges

A

traders use many markets to exchange one type of asset for another that has a specific use

47
Q

Utilitarian Traders: Risk Exchanging (Hedging)

A

hedgers use the market to reduce exposure to financial risk

- hedge = two risks offsetting

48
Q

Utilitarian Traders: Gambling

A

allows people to take positions on uncertain future events

- hope to make money but have no rational reason to expect to

49
Q

Utilitarian Traders: Tax Reasons

A

use markets to minimise tax paid

traders look for liquid markets (low transaction costs) in a market structure

50
Q

Speculators

A

Informed Traders who expect a conditional return
Rf + Rprem + Rinfo

Collect, analyse and produce information that is used to predice future price changes

51
Q

Informed Traders

A

profit from knowing fundamental value (expected NPV of all future benefits and costs associated with holding the security)

  • minimise price impact to maximise profit
  • trade aggresively to utilise information before it becomes public knowledge
  • trade slowly if they know information will not become public knowledge
52
Q

Parasitic Traders

A

sentiment oriented technical traders predict tradesthat uninformed traders will decide to make

53
Q

Futile Traders

A

trade on what they falsely believe to be special information or misinterpret useful information
- can distort prices from fundamental value

54
Q

Value-Motivated Traders

A

estimate fundamental value using economic models

55
Q

Headline Traders

A

estimate changes in fundamental values

56
Q

Information Oriented Technical Traders

A

Try forecast prices from past prices and other market data

57
Q

Arbitrageurs

A

relative differences in fundamental values using fundamental and technical models

58
Q

Market Efficiency

A

Low cost market is more efficient

59
Q

Value-Motivated Traders

A

estimate fundamental value using economic models

60
Q

Headline Traders

A

estimate changes in fundamental values

61
Q

Information Oriented Technical Traders

A

Try forecast prices from past prices and other market data

62
Q

Arbitrageurs

A

relative differences in fundamental values using fundamental and technical models

FINA3307 (7 decks)

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