week 6

Question 1

 Efficiency and fairness

Answer 1

o	Efficiency comes in two forms
	Pareto Efficiency
	Informational efficiency
o	Ensure all markets have information accessible to all investors, investors have same beliefs at a certain point in time
o	Relates to fairness

Question 2

 Pareto Efficiency

Answer 2

• Exists when no other feasible allocation of resources and technology can improve one person’s situation without harming that of another
• Can not allocate resources to improve one person without harming another

Question 3

 Informational efficiency

Answer 3

• Achieved when all investors hold objective beliefs and information in common, so that competitive prices accurately reflect that information

Question 4

 Some financial regulations

Answer 4

o Insider trading regulations
o Mandatory disclosure regulations
o Margin regulations
o Trading interruption regulations

Question 5

 What is inside information?

Answer 5

o Material information obtained from management that is not widely available to the public
 What about information obtained from someone who obtained it from management?
 Needs to be a) material b) not widely available to the public, obtained from management
o Managers must control the dissemination of material managerial information
 It must either be widely publicized or kept secret
o Defining inside information in court is difficult

Question 6

 What is inside trading?

Answer 6

o Illegal insider trading traditionally defined as “execution of transactions on the basis of material non-public information”
o Registered insiders are forbidden from trading on material non-public informed based on
 The disclose-or-abstain theory
 The misappropriation theory
 Either disclose information or keep it public
o How about temporary insiders?
 E.g. takeovers
 Cannot do it

Question 7

 Insider trading regulations in Australia

Answer 7

o Defined as information that is not generally available, if it were so, a reasonable person would expect it to have a material effect on the price or value of a financial product
 Reasonable person -> e.g. management -> barber -> to you (you can be reasonable)
o ASX listing Rule requires an entity to report to the ASX any material information
 Serious offense

Question 8

 Why have insider trading rules?

Answer 8

o Public demands fairness
 Traders have a right to equal information
 Insiders are misappropriating information that does not belong to them
o Protect dealers and limit order traders from inside traders
o To remove unwanted distortions in the managerial labour markets

Question 9

 What are likely effects of insider trading rules?

Answer 9

o Effectively enforced insider trading rules see reduction in the adverse selection spread components

o More capital will be saved by uniformed traders when
 Liquidity is cheap
 Markets are widely believed to be fair

o Price may be less efficient in the short run
 Managers release information when they trade
 Lower without insider trading

Question 10

 Arguments for permitting insider trading

Answer 10

o Rules cost too much to enforce

o May increase liquidity by quickly eliminating information asymmetries

Question 11

 Corporate problems with insider information

Answer 11

o If managers can trade on inside information
 Will they share information with the public, the board and other competing insiders? They will hide information
 Effects on management decisions that impacts on information asymmetries?
• Increase information asymmetry
 Effects on shareholder values?

Question 12

 Can insiders trade legally?

Answer 12

o Registered insiders usually own shares in their own companies
 They may trade in these shares provided they inform the regulators about their trades and do not trade on material non-public information

o Is there any information in insiders’ trades?
 Permanent price effects if they do trade

Question 13

 HFT Overview

Answer 13

o High frequency trading
o The effect of trading technology have been most profound with respect to speed
o Fragmented
o Opaque and complex rules
o Business model of stock exchanges varies

Question 14

 Definition of HFT

Answer 14

o Algorithms for decision marking, order initiation, generation, routing, or execution, for each individual transaction without human direction
o Low-latency technology that is designed to minimize response times including proximity and colocation services
o High speed connects for markets of order entry
o Recurring high message rates determined using one or more objective forms of measurement

Question 15

 Latency Arbitrage

Answer 15

o Different traders learn about current market conditions at different times
o A low latency player can appear to predict the future from the perspective of a high latency player
o Refers to a class of strategies that exploit these differences
o Has a well-defined market benefit
 Law of one price
o Information of order flow; not information asymmetry -> doesn’t generate value, just exploits latency difference
o Socially worse off; expensive and only those who are in the industry can benefit

Question 16

 Layering

Answer 16

o HFT enters limit orders at different price levels away from the market price, often to cancel the orders in the near future and then to re-submit the orders again
o It is a legitimate strategy; market markers leave placeholder limit orders at different price points with the intent of securing time priority in a given price queue of a limit order book

Question 17

 Quote stuffing

Answer 17

o Intention is to clog the networks and the matching engine with a large number of limit orders and order cancellations
o Unlike layering – quote stuffing is thought to send in rapid orders and cancellations with the purpose of slowing down other traders -> manipulating markets

Question 18

 Spoofing

Answer 18

o Trader intentionally distort the order book without execution
o Changing other trader’s inferences about available supply and demand and resulting prices
o Illegal