Week 5 - Adverse selection, Trading and spreads

Question 1

How do dealers make profit?

Answer 1

They profit from supplying liquidity to markets

They are passive traders and have no choice who they trade with

Question 2

What decisions must dealers make when quoting prices?

Answer 2

1. Price
   - What level to buy/sell
2. Bid-ask Spread
3. Size of quote
   - volume they are willing to trade

Question 3

What is a bid-ask spread?

Answer 3

The difference between a persons bid/ask price

Question 4

What is a “inside spread”

Answer 4

The difference between NBB and NBO

• Usually narrower than dealer spreads

Question 5

What is the effective spread?

Answer 5

The difference between prices that a dealer actually trades

-Gets adjusted after every trade

Question 6

What is a dealers goal when setting a bid-ask spread?

Answer 6

To maximise profit

Question 7

When are narrow bid-ask Spreads used?

Answer 7

In competitive market to encourage trading with the dealer

Question 8

When are wide bid-ask Spreads used?

Answer 8

in monopoly markets to get higher profits

Question 9

What is “adverse selection”?

Answer 9

The tendency for high risk individuals to seek insurance coverage

Question 10

What is “adverse selection” in trading?

Answer 10

When a trader with special information uses it to their advantage and to the expense of a counter-party

Question 11

What is the “Kyle Trading Model (1985)”

Answer 11

A model that describes the trading behaviour of informed traders and uninformed market makers in an environment with noise traders

Question 12

What does the kyle trading model say regarding dealer price setting?

Answer 12

The function of a dealers pricing is a function of supply and demand

Question 13

What is “kyle’s lamda”?

implications?

Answer 13

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

Question 14

What are the implications for informed traders in Kyles trading model?

Answer 14

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

Question 15

What are the implications for dealers in Kyles trading model (1985)?

Answer 15

Dealer markets cannot exist without liquidity traders

Question 16

What does Kyle’s trading model say the costs to dealers come from?

Answer 16

1. Cost of ignorance
   - Informed traders profit from dealers
2. Cost of carrying an unbalanced inventory
   - Dealers may need to over pay / discount sell assets to rebalance inventory

Question 17

What are the two components of a dealers bid-ask spread?

Answer 17

1. Transaction costs component
2. Adverse selection component

Question 18

What is included in a dealers bid-ask transaction cost component?

What determines this component’s cost?

Answer 18

includes:
costs related to running the firm/market

Determined by:
1. Trading volume
2. Number of dealers + limit order traders

Question 19

What happens if a dealer only charges for transaction costs?

Answer 19

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

Question 20

What is included in the adverse selection component of a dealers bid-ask spread?

Answer 20

1. 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

Question 21

What do empirical studies say about asymmetric information and price changes?

Answer 21

Studies say:
Asymmetric information produces positive serial correlation in price changes

Question 22

What is the information asymmetry Model best estimate equation?

Answer 22

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

Question 23

What is the best estimate equation for a dealers ask price?

Answer 23

Equation:
V+Eq

=> If trader is informed: Value = V+E
=> If trader uninformed: Value = v

Question 24

What is the best estimate equation for a dealers bid price?

Answer 24

Equation:
V-Eq

=> If trader is informed: Value = V-E
=> If trader uninformed: Value = v

Question 25

What is a dealers bid-ask spread according to the best estimate equation?

Answer 25

Equation:
(V+Eq) - (V-Eq)

=> 2qE

Question 26

What does it mean if q is large?

What should the dealer do?

Answer 26

If q large:
There are many informed traders

Dealer should:
widen spread

Question 27

What does it mean if E is large?

What should the dealer do?

Answer 27

If E is large:
Information known by informed traders is important

Dealer should:
Widen spread

Question 28

What types of situations require larger spreads?

Answer 28

Mining stocks
(private information)

Contracts on individual stocks

Firms with poor accounting practices