Week 5 - Adverse selection, Trading and spreads Flashcards
How do dealers make profit?
They profit from supplying liquidity to markets
They are passive traders and have no choice who they trade with
What decisions must dealers make when quoting prices?
- Price
- What level to buy/sell - Bid-ask Spread
- Size of quote
- volume they are willing to trade
What is a bid-ask spread?
The difference between a persons bid/ask price
What is a “inside spread”
The difference between NBB and NBO
- Usually narrower than dealer spreads
What is the effective spread?
The difference between prices that a dealer actually trades
-Gets adjusted after every trade
What is a dealers goal when setting a bid-ask spread?
To maximise profit
When are narrow bid-ask Spreads used?
In competitive market to encourage trading with the dealer
When are wide bid-ask Spreads used?
in monopoly markets to get higher profits
What is “adverse selection”?
The tendency for high risk individuals to seek insurance coverage
What is “adverse selection” in trading?
When a trader with special information uses it to their advantage and to the expense of a counter-party
What is the “Kyle Trading Model (1985)”
A model that describes the trading behaviour of informed traders and uninformed market makers in an environment with noise traders
What does the kyle trading model say regarding dealer price setting?
The function of a dealers pricing is a function of supply and demand
What is “kyle’s lamda”?
implications?
Defined:
a variable of a dealers price function that accounts for a dealers sensitivity of price to order flow
=> dealers perception of a security’s sensitivity of price to order flow
Implications:
If fundamental value is noisey = High intrinsic value volatility
= > dealer becomes more sensitive to price adjustments
If variance of uninformed traders is high
=> dealer does not need to be sensitive to price changes
What are the implications for informed traders in Kyles trading model?
If volume is high, informed traders will trade aggressively as they can hide their intentions from dealer
If information is significant => informed trader’s volume drops to hide intentions
What are the implications for dealers in Kyles trading model (1985)?
Dealer markets cannot exist without liquidity traders
What does Kyle’s trading model say the costs to dealers come from?
- Cost of ignorance
- Informed traders profit from dealers - Cost of carrying an unbalanced inventory
- Dealers may need to over pay / discount sell assets to rebalance inventory
What are the two components of a dealers bid-ask spread?
- Transaction costs component
- Adverse selection component
What is included in a dealers bid-ask transaction cost component?
What determines this component’s cost?
includes:
costs related to running the firm/market
Determined by:
1. Trading volume
2. Number of dealers + limit order traders
What happens if a dealer only charges for transaction costs?
Without new information, trade prices will bounce directly between bid/ask prices
=> negative serial correlation in price changes
If new information comes, dealers will go out of business due to informed traders
What is included in the adverse selection component of a dealers bid-ask spread?
- The difference in a dealers value estimate conditional on the next trader being a buyer or seller
=> portion of spread that covers losses to informed traders
=> paid by uninformed traders
What do empirical studies say about asymmetric information and price changes?
Studies say:
Asymmetric information produces positive serial correlation in price changes
What is the information asymmetry Model best estimate equation?
Best estimate equation:
V(1-q) + q(V+E)
q = probability that next buyer is informed
E = error in dealer’s estimate of value if next buyer is informed
What is the best estimate equation for a dealers ask price?
Equation:
V+Eq
=> If trader is informed: Value = V+E
=> If trader uninformed: Value = v
What is the best estimate equation for a dealers bid price?
Equation:
V-Eq
=> If trader is informed: Value = V-E
=> If trader uninformed: Value = v
What is a dealers bid-ask spread according to the best estimate equation?
Equation:
(V+Eq) - (V-Eq)
=> 2qE
What does it mean if q is large?
What should the dealer do?
If q large:
There are many informed traders
Dealer should:
widen spread
What does it mean if E is large?
What should the dealer do?
If E is large:
Information known by informed traders is important
Dealer should:
Widen spread
What types of situations require larger spreads?
Mining stocks
(private information)
Contracts on individual stocks
Firms with poor accounting practices
