Lecture 5

Question 1

What is the effective spread?

Answer 1

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

Question 2

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

Answer 2

NO they can be different.

Question 3

How do effective spreads arise?

Answer 3

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

2. Dealers adjust their quotes between trades.

Question 4

Why do dealers adjust spreads between trades?

Answer 4

As they observe the market

Question 5

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

Answer 5

To maximize their profits

Question 6

How big the dealers spreads are depends on what?

Answer 6

How much competition is in the market.

Question 7

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

Answer 7

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

Question 8

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

Answer 8

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

Question 9

What is adverse selection in financial trading?

Answer 9

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

Question 10

Kyle (1985) theoretical model describes:

Answer 10

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

Question 11

What kind of auction model is Kyle’s:

Answer 11

one-single price auction model

Question 12

Who is in this one-single price auction?

Answer 12

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

Question 13

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

Answer 13

Supply and Demand

Question 14

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

Answer 14

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

Question 15

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

Answer 15

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

Question 16

If the dealer thinks the market is sensitive that means:

Answer 16

That the dealer believes there are a lot of informed traders

Question 17

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

Answer 17

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

Question 18

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:

Answer 18

• 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.

Question 19

The dealer’s cost comes from 2 things:

Answer 19

1. Cost of ignorance: informed traders know more.

2. Cost of carrying unbalance inventory:

Question 20

What is negative serial correlation?

Answer 20

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.

Question 21

What are a dealer’s transaction cost components:

Answer 21

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

Question 22

What determines the transaction costs?

Answer 22

1. Trading Volume

2. Number of dealers and limit order traders

Question 23

When do positive serial correlation in price changes?

Answer 23

Asymmetric information tends to produce positive serial correlation in price changes

Question 24

In the information asymmetry model:

what is p?

Answer 24

probability that the next buyer is a well informed trader

Question 25

In the information asymmetry model: | what is E?

Answer 25

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

Question 26

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

Answer 26

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

Question 27

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

Answer 27

ask price= V + pE

Question 28

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

Answer 28

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

Question 29

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

Answer 29

bid price= V - pE

Question 30

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

Answer 30

(V + pE) - (V - pE) | =2pE

Question 31

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

Answer 31

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

Question 32

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

Answer 32

Transaction Cost Component

Question 33

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

Answer 33

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

Question 34

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

Answer 34

1. Patient Precommitted Traders | 2. Value-Motivated Traders

Question 35

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

Answer 35

* 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.

Question 36

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

Answer 36

* 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. * ••

Question 37

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

Answer 37

* 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 * •••

Question 38

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

Answer 38

•To provide liquidity

Question 39

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

Answer 39

•To take liquidity•••••

Question 40

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?

Answer 40

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

Question 41

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

Answer 41

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