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FINA3307 > Lecture Four > Flashcards

Lecture Four Flashcards

1
Q

Trading

A

zero sum game where the total gains of the winners are exactly equal to the total loss of the losers

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2
Q

Returns are positive for winners

A

comparative advantage

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3
Q

Returns are negative for losers

A

get some benefit from trading

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4
Q

Profit motivated

A

trade to make a profit

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5
Q

Utilitarian

A

trade for other reasons

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6
Q

Futile

A

trade to make profits but fail

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7
Q

Investment and Divestment

A
  • Individuals often need to manage their cash flow, moving money from one point in time to another
  • Investors are uninformed traders who use the markets to obtain an unconditional rate of return
  • real risk free + risk premium
  • Do NOT know fundamental value of asset
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8
Q

Risk sharing

A

large projects are often too risky to be financed by individuals

  • divide up projects among many owners to distribute risks
  • pieces (shares and bonds) are marketed)
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9
Q

Asset exchanges

A

traders use many markets to exchange one type of asset (usually money) for another that has some specific use
- e.g forex, spot commodities exchange

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10
Q

Risk exchanging (hedging)

A

hedgers use financial markets to reduce their exposure to financial risk

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11
Q

Gambling

A

securities markets allow people to take positions on uncertain future events, likely that some gamblers would also trade financial instruments

hope to make money but have no rational expectation to

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12
Q

Tax reasons

A
  • tax system provides opportunity for tax avoidance
  • tax avoiders use market to minimize taxes paid
  • different in tax rates on dividends and capital gains/losses
  • deferral of taxable income
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13
Q

Utilitarian traders look for

A

liquid markets with low transaction costs

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14
Q

Speculators

A

informed traders who expect a conditional return

speculators collect, analyse, and produce information that is then used to predict future price changes

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15
Q

Speculators differ by the information they use to forecast future price changes:

A

Informed traders: profit from knowing fundamental values

Parasitic traders (include order anticipators and bluffers)

  • act on information about other traders’ orders
  • create information to fool others
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16
Q

Sentiment-oriented technical traders

A

predict trades that uninformed traders will decide to make

  • trade ahead of uninformed traders
  • profit when prediction is correct
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17
Q

Squeezers monopolies one side of the market

A
  • most common buying up supply thus controlling subsequent sales prices
  • common in commodity markets
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18
Q

Dealers:

A

profit motivated traders who profit by supplying liquidity to other traders who want to trade

  • liquidity service they sell, immediacy, is valuable to impatient traders
  • dealers often known as specialists or market-makers in stock exchanges and options exchanges
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19
Q

Futile traders

A

noise traders

  • trade on what they falsely believe to be special information
  • if they trade in large numbers and if trading behavior is correlated, they may distort prices from fundamental value
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20
Q

Informed traders

A
  • fundamental value of a security is the expected NPV of all future benefits and costs associated with holding the security
  • value agreed upon if everyone knew every available piece of information
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21
Q

Informed trading strategies

A
  • profit motivates informed traders NOT desire to make prices more informative
  • informed traders try to minimize their price impact to maximize their profits
  • trade aggressively to utilize informational advantage before it becomes public knowledge
  • trade slowly if they know information will not become public knowledge: stealth trading
22
Q

What is the effect of informed trading on price?

A
  • trading by informed traders moves price towards the security’s fundamental value
  • informed traders have different information, thus they form different estimates of value
  • market price is more informative than the single estimate from one informed trader
23
Q

Styles of informed trading

A
  • value motivated traders
  • headline traders
  • information-orientated technical traders
  • arbitrageurs
24
Q

Informed traders profit when they trade with uninformed traders

A

Actions of informed traders cause the markets to have informative prices

25
Q

Market efficiency

A

Prices are efficient with respect to a set of information if traders cannot profit from acquiring the information and trading on it

26
Q

At equilibrium cost of acquiring and trading on info =

A

revenue from information

27
Q

Dealers and bid-ask spread

A

dealers are profit motivated who supply liquidity to other traders (passive traders)

  • respond to demands for liquidity
  • quote prices which they are willing to buy and sell
28
Q

Dealer Quotes

A

Sizes they are willing to trade

Quoted bid-ask spread can be different from inside spread and different from effective spread

29
Q

Effective Spread

A

difference between the prices at which the dealers actually buy and sell

  • traders trade with dealer at prices inside the quote
  • dealers adjust their quotes between trades
30
Q

narrow spread

A

encourages others to trade with them

31
Q

wide spread

A

recover costs of doing business

32
Q

adverse selection:

A

tendency of higher risk individuals to seek insurance coverage
non-diversifiable risk

33
Q

financial adverse selection

A

informed traders select profitable side of market to trade

34
Q

Lessons from Kyle’s (1985) model:

A
  • if noise trader volume increases, informed trader’s trade volume INCREASES
  • if information that informed trader has is significant, informed trader’s trade volume DECREASE
35
Q

Dealers’ costs come from:

A
  • cost of ignorance
  • hit by better informed traders
  • cost of carrying an unbalanced inventory
36
Q

If dealer only charges for transaction costs:

A

transaction prices will bounce between quoted bid and ask

Negative serial correlation in price changes

37
Q

transaction cost component covers:

A
  • dealers’ time
  • memberships, dues and data feeds
  • back office operations
  • monopolistic rents
38
Q

determinants of transaction cost:

A
  • trading volume

- number of dealers and limit order traders

39
Q

if dealers set spreads to cover only transaction costs, eventually will go out of business

A
  • need to widen spread to cover their losses to informed traders
  • adverse selection spread component
40
Q

Asymmetric information tends to:

A

produce positive serial correlation in price changes

41
Q

Best estimate of value is

A

(1-q) V + q ( V+E)

Ask price = V + qE

Bid price = V - qE

Bid-ask spread is 2qE

42
Q

transaction cost component should have __ long-run effect on price because it is unrelated to information

A

no

43
Q

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

A

permanent

44
Q

Who supplies liquidity in an order driven market?

A

Designated Market Makers

  • Patient precommitted traders
  • Value-motivated traders
45
Q

Take liquidity

A

submitting a market order and enabling another investor’s limit order to execute

46
Q

Information event

A

news that affects all investors’ assessment of a security’s share value

47
Q

liquidity event

A

events that are unique to the individual trader

48
Q

What must bid-ask spread be equal to have an indifference between limit and market orders?

A

zero

49
Q

Designated Market Makers

A

firms that offer trading services
obligations: maintain maket liquidity for certain stocks
May get the benefit of monetary incentives i.e. declining fee schedule

50
Q

Limit Order Market

A
  • limit order traders (LOT) will lose if only an information event occurs
  • arrival of liquidity motivated traders creates a profit opportunity for LOT

Each investor determines whether to:

  • take liquidity: take a market order and enable another investors limit order to execute
  • provide liquidity: place a limit order and enable another investor to buy or sell via market order

FINA3307 (7 decks)

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