week 5

Question 1

 Dealers and the bid-ask spread

Answer 1

o Profit motivated traders who profit by supplying liquidity to other traders who want to trade
o Quote prices at which they are willing to buy and sell

o It is a business, they have to decide the price that they want to quote
o All of their business relies on order influx, trading against them = making profit
o In order to attract more people to train against them, quote a narrow spread
o How narrow / wide the spread is depending on the competition in the market
 Monopolistic dealers (wide)
 Competitive dealer markets (narrow)
 E.g. airport -> high spread, city -> low spread for currency (narrow spread)

Question 2

 Inside Spread

Answer 2

o Lowest ask price between all bidders and highest buy price
o Best ask and bid in the market
o Also known as quoted spread
o Pre-trade measure

Question 3

 Effective Spread

Answer 3

o Difference between the prices at which the dealers actually buy and sell
o Traders trade with dealer at prices inside the quote
o Dealers adjust their quotes between trades
o Almost always within the quoted spread / inside spread
o Post-trade measure

Question 4

 What is adverse selection?

Answer 4

o Tendency of higher risk individuals to seek insurance coverage
o Dealers essentially have no information vs informed traders -> they are very scared to trade against these informed traders
o Describes information asymmetry, less information = more disadvantage

o In financial trading ‘adverse selection occurs when one trader with secret or special information uses that information to her advantage at the expense of her counterparty in trade

Question 5

 Lessons from Kyles (1985) Model

Answer 5

o Two rational traders have access to the same information and are otherwise identical -> they will not trade
o If they have access to different information -> they will likely not trade either -> may believe their information is not suffice to devise the price.
o This theoretical model describes the trading behaviour of informed traders and uninformed market makers in an environment with noise traders
o Trading will only occur if you have the skills to interpret the information & have all the information

Question 6

o Who are in this one-period single price auction model?

Answer 6

 Single Dealer
• Observe demand and supply in auction and set price accordingly
 Many uninformed noise traders
• Trade requirement is random but has a distribution that is known
 Single informed trader with perfect information
• Seek to disguise himself and information
• Determine the optimal trade quantity to maximise profit
 All are risk neutral, no spread, money has no time value

Question 7

o How does the dealer set his price?

Answer 7

 Dealer’s pricing is related to the demand and supply in the market
 Depends on the dealer’s perception of sensitivity of intrinsic value to volume
 If informed trader is known to dominate -> very conservative of price and volume; very quick
 Dealer’s price adjustment also depends on the volatility in the intrinsic value and variance in uninformed traders’ trading
• If volatility in the intrinsic value is high -> adjust slowly
• If the variance in uninformed traders’ trading is high -> adjust slowly as well

Question 8

o Implications for the informed trader

Answer 8

 If noise trader volume increases, informed trader can exploit this noise to hide yourself -> can trade more aggressively
 If the information is significant -> trade less; but try to hide their strategy?

Question 9

 Dealer’s costs come from

Answer 9

o Cost of ignorance
 Hit by better informed traders
o Cost of carrying an unbalanced inventory
 Come from liquidity traders

Question 10

 The components of the bid-ask spread

Answer 10

o Transaction cost component -> transaction prices will bounce between the quoted bid and ask
o Negative serial correlation in the price changes
o Covers
 Dealers time
 Membership feeds
 Bank office operations
 Monopolistic rents; if any

Question 11

 Determinants of transact cost

Answer 11

o Trading volume

o Number of dealers and limit order traders

Question 12

 The components of the bid-ask spread

Answer 12

o If spread only covers transaction costs -> go out of business
o Need to widen spread to cover their losses to informed traders
o Adverse selection spread component
o Asymmetric information tends to produce positive serial correlation in price changes

Question 13

 Information asymmetry model

Answer 13

P = probability that the next buyer is a well informed trader
E = Error in the dealer's estimate of value if the next buyer is well informed

If the next buyer is well informed, then value V+E
Next buyer is uninformed, value V
Ask price = V+pE

If the next seller is informed, value V-E
Uninformed seller, V
Bid Price = V-pE

Bid-ask spread is V+pE minus V-pE
ie. 2pE

Question 14

 Adverse Selection spread and information asymmetry

Answer 14

o Many informed traders -> probability high -> adverse selection spread wider
o Material information -> E is large -> Higher spread
o Mining stocks -> tend to have a wider spread
o Contracts on macro variables vs individual stocks -> individual has higher spread
o Firms with poor accounting systems -> higher spread

Question 15

 Discriminating between the two spread components

Answer 15

o Transaction cost component should have no long-run effect on price -> unrelated to information
o Price changes due to adverse selection component have a permanent effect on prices as dealers infer values from the order flow

Question 16

 Simple model of the order-driven market

Answer 16

o In an order driven market; each investor individually determines whether to
 Place a limit order and enable another investor to buy/or sell by market order
• Provide liquidity
 Submit a market order and enable another investor’s limit order to execute
• Take liquidity

Question 17

 Two Events Possible

Answer 17

o News that affects all investor’s assessment of a security’s share value
 Information event
o Events that are unique to an individual trader
 Liquidity event
o If only information event occurs, then the limit order traders will always lose

Question 18

Who supplies liquidity in an order driven market?

Answer 18

Patient precommitted traders
-> use limit orders to lower cost of trades they msut make
Risk failing to trade when market moves awy from their limit orders

Value-motivated traders

• > Provide liquidity when they trade securities perceived to be mispriced
• > They provide depth at substantial cost and are the ultimate source of depth

Question 19

Simple model of the order-driven market

Answer 19

o	Suppose that all traders in this market are homogenous
	Want to trade the same size
	No one requires immediacy
	No information asymmetry
	Costless to amend, cancel orders

Question 20

o What determines the spread in an order-driven market?

Answer 20

 What is the round trip cost of trading using
• Market orders? -> bid ask spread
• Limit orders? Nothing
 What must the bid-ask spread be equal to have an indifference between limit and market orders?
• Zero
 Some of the assumptions are not realistic
• Costly limit order management
• Asymmetrically informed traders