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Trading: Securities and the Market > Lecture 5 > Flashcards

Lecture 5 Flashcards

1
Q

What is the effective spread?

A

The effective spread is the difference between the prices at which the dealers actually buy and sell.

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2
Q

Is the effective spread the same as the quoted bid-ask spread?

A

NO they can be different.

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3
Q

How do effective spreads arise?

A
  1. Traders trade with dealer at prices inside the quote.

2. Dealers adjust their quotes between trades.

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4
Q

Why do dealers adjust spreads between trades?

A

As they observe the market

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5
Q

In the dealer market, dealer will set their bid-ask spread to achieve what?

A

To maximize their profits

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6
Q

How big the dealers spreads are depends on what?

A

How much competition is in the market.

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7
Q

When the spread of a dealer is narrow this means the market is?

A

Competitive dealers are trying to encourage traders to trade with them.

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8
Q

When the spread of a dealer is wide this means the market is?

A

To make more profit and recover the costs of doing business.

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9
Q

What is adverse selection in financial trading?

A

occurs when one trader with special information uses that information to her advantage at the expense of her counter party in trade

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10
Q

Kyle (1985) theoretical model describes:

A

the trading behavior of informed traders and uniformed market makers in an environment with noise traders and liquidity traders.

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11
Q

What kind of auction model is Kyle’s:

A

one-single price auction model

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12
Q

Who is in this one-single price auction?

A
  1. Single Dealer
  2. Many uniformed traders
  3. Single informed trader with perfect information
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13
Q

The dealers price function is related to what in the market?

A

Supply and Demand

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14
Q

the dealers pricing function is related to the supply and demand and further the dealer’s perception of what?

A

the dealer’s perception of sensitivity of the intrinsic value to volume

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15
Q

what does the dealer’s perception of sensitivity of the intrinsic value to volume mean?

A

that as a dealer they can observe the order flow when their is an increase in supply or demand then I can see that something has changed with the fundamental value of the security

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16
Q

If the dealer thinks the market is sensitive that means:

A

That the dealer believes there are a lot of informed traders

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17
Q

If the dealer thinks the market is not sensitive that means:

A

That the dealer believes there are a lot of liquidity or noise traders and not many informed traders.

18
Q

What are the implications of Kyle’s model for informed traders?
-if noise trader volume increases how will an informed trader trade:

-if the information that the informed trader has is significant how will the informed trader trade:

A
  • I will trade in a higher volume
  • if information is significant then the value of a stock will change a lot. The trader will not have to trade large quantities to maximize profit.
19
Q

The dealer’s cost comes from 2 things:

A
  1. Cost of ignorance: informed traders know more.

2. Cost of carrying unbalance inventory:

20
Q

What is negative serial correlation?

A

what you observe if dealer did not change their valuation idea and trade at the bid-ask across time then the prices themselves will have negative correlations.

21
Q

What are a dealer’s transaction cost components:

A
  1. The dealer’s time
  2. Memberships, dues and data fees
  3. back office operations
  4. monopolistic rents
22
Q

What determines the transaction costs?

A
  1. Trading Volume

2. Number of dealers and limit order traders

23
Q

When do positive serial correlation in price changes?

A

Asymmetric information tends to produce positive serial correlation in price changes

24
Q

In the information asymmetry model:

what is p?

A

probability that the next buyer is a well informed trader

25
Q

In the information asymmetry model:

what is E?

A

dealer’s estimate of value of the error the dealer will have made if the next dealer is informed

26
Q

If a buyer comes to a dealer and the dealer is unsure is buyer is informed or uniformed what is the probability:

A

(1-p)V + p(V+ E)

27
Q

The ask price the dealer will charge (to sell a security) in information asymmetry model?

A

ask price= V + pE

28
Q

If a seller comes to a dealer and the dealer is unsure is buyer is informed or uniformed what is the probability:

A

(1-p)V + p(V - E)

29
Q

The bid price the dealer will charge ( to buy a security) in information asymmetry model?

A

bid price= V - pE

30
Q

What is the bid ask spread given the probability formula in information asymmetry model?

A

(V + pE) - (V - pE)

=2pE

31
Q

What does the information asymmetry model calculation tell us about how the dealer will set the price ?

A

that the dealer will set the price dependent on the probability of the informed traders in the market and the error amount they are likely to make

32
Q

In the spread component what component should have no long run effect on price because it is unrelated to information?

A

Transaction Cost Component

33
Q

In the spread component what component has a permanent effect on prices?

A

Price changes due to the adverse selection component have a permanent effect on prices as dealers infer values from the order flow.

34
Q

Who supplies liquidity in a order driven market (2 people)?

A
  1. Patient Precommitted Traders

2. Value-Motivated Traders

35
Q

Who are Patient Precommitted Traders, how do they trade, and what risks do they face?

A
  • They are liquidity traders.
  • Use limit orders to lower cost of trades they must make.
  • Risk failing to trade when market moves away from their limit orders.
36
Q

Who are Value-Motivated Traders, how do they trade, and their trading methods?

A
  • Pre-committed traders who have meet their liquidity shock
  • they provide depth at substantial cost (spread)
  • they straddle if they think the value is $34 bid below $34 and ask above $34.
  • ••
37
Q

In an order driven market, each investor individually determines whether to (limit or market):

A
  • Place a limit order and enable another investor to buy or sell by market order
  • Submit a market order and enable another investor’s limit order to execute
  • •••
38
Q

What is the role of a investor who places a limit order in terms of liquidity?

A

•To provide liquidity

39
Q

What is the role of a investor who places a market order in terms of liquidity?

A

•To take liquidity•••••

40
Q

What is an event of news that affects all investors’ assessment of a security’s share value and is this good or bad for a liquidity trader?

A

Information Event

Bad; as the share price will move permanently away from limit order

41
Q

What is an event that are unique to an individual trader and is this good or bad for a liquidity trader?

A
  • Liquidity Event
  • Good for liquidity traders as prices will drop and then slowly increase back giving the limit order a chance to be filled

Trading: Securities and the Market (7 decks)

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