week 4

Question 1

 Why do people trade?

Answer 1

o	Trading is a zero-sum game
o	Returns is positive for winners
o	Negative for losers
o	Suggests
	Some trade for profit
	Other reasons (utilitarian)
	Trade to make profits but fail (futile)

Question 2

 Utilitarian traders / Liquidity traders

Answer 2

o	Trade because they expect to obtain some benefit from trading besides trading profit
o	Investment and disinvestment
	Individuals often need to manage their cash flow, moving 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
o	Risk sharing
o	Asset exchanges
	Exchange one type of asset for another
•	E.g. foreign currency exchange
•	Spot commodities
o	Risk exchanging
	Hedging
	Reduce their exposure to financial risk
	Two risks offsetting each other
o	Gambling
o	Tax Reasons

Question 3

 What do utilitarian traders look for in market structure?

Answer 3

o Liquid markets -> low transaction costs

o Can implement their strategy

Question 4

 Why do people trade? Speculators

Answer 4

o Speculators are informed traders who expect a conditional return
o Collect, analyse and produce information that is then used to predict future
o Speculators are rational, gamblers are not
o Speculators should be compensated for the time / resources they have used

Question 5

 Parasitic traders

Answer 5

o Benefit from other people’s trades
o Information is based on public information -> predict incoming trades
o Act on information about other traders’ orders
o Create information to fool others
o Squeezers monopolise one side of a market
 More common buying up the supply thus controlling subsequent sale prices
 Most common in commodity markets

Question 6

 Dealers

Answer 6

o Profit motivated
o Supply liquidity to other traders who want to trade
o Immediacy is valuable to impatient traders
o Often are known as specialists or market makers in stock exchanges and options exchanges
o Make money by / who supply liquidity

Question 7

 Futile Traders

Answer 7

o Noise traders

o Trade on what they falsely believe to be special information / misinterpret

Question 8

 Informed traders

Answer 8

o Fundamental value of a security expected NPV
o Value agreed upon -> a speculated value
o Undervalued -> buy
o Overvalued to profit when the price reverts to their estimate of the fundamental value -> sell

Question 9

 Informed trading strategies

Answer 9

o Profit motivates informed traders and NOT a desire to make prices more informative
o They try to minimize their price impact -> maximise profits
 Trade aggressively to utilise the informational advantage
 Trade slowly if they know the information not become public knowledge

Question 10

 Informational efficiency and prices

Answer 10

o Price incorporates information
 Based on trading; to realize profits -> information must be made public
o Degree to which market prices correctly and quickly reflect information depends on trading behaviour
 Actions of informed traders cause the markets to have informative prices
o Milgrom and Stokey -> no trade theorem
 Noise traders are necessary

Question 11

 A market microstructure definition of market efficiency

Answer 11

o Prices are efficient with respect to a set of information if traders cannot profit from acquiring the information and trading on it
o At the equilibrium: cost of acquiring and trading on info = revenue from info