Lecture Two

Question 1

Market Structure

Answer 1

trading rules and trading systems used by market

- affects information asymmetry in market and who trades profitably

Question 2

Trading Sessions

Answer 2

• Call: trades take place when market is called

- Continuous: arrange traders when market is open

Question 3

Execution systems

Answer 3

• Quote-driven: dealers arrange trades with customers
• Order-driven: trades are arranged via order precedence rule and trade pricing rule
  Brokered: help buyers and sellers find each other
• Hybrid

Question 4

Information Systems

Answer 4

• Information collection

- Order routing/presentation

Question 5

Quote driven Markets

Answer 5

In pure quote markets, public traders cannot arrange trades among themselves

• dealers supply liquidity and quote bid/ask prices
• information asymmetry: dealers can choose who they trade with
• dealer profit comes from beta spread

Question 6

Order-driven markets

Answer 6

All traders issue orders to the exchange

Trade without intermediation of dealer

Question 7

Brokered markets

Answer 7

Trade initiators contacts broker who then finds counter parties

• do not observe liquidity
  Item traded is somehow unique and when dealers are unwilling to hold inventories (illiquid)

Question 8

Hybrid markets

Answer 8

Most common: dealer-specialist

- order-driven auction markets in which the specialist must provide liquidity under some circumstances

Question 9

Information systems

Answer 9

bring info in/out of market

• info collection systems
• info distribution systems
• order routing systems
• order presentation systems

Question 10

Order presentation systems

Answer 10

manage exchange of info about orders and present them for consideration

• open outcry auctions (oral auctions)
• board-based trading systems
• screen based trading systems

Question 11

Order books

Answer 11

• manage and store info about standing orders:
• electronic or paper based

Hold extremely valuable info

• front running opportunities
• arbitrage

Traders need to leave standing limit orders in the order books for order-book matching to work
- some traders do not want to show their orders

Question 12

Price steps

Answer 12

minimum price multiples for a security

- depends upon the market price of security

Question 13

Transparency Markets

Answer 13

report complete information to the public quickly

• Ex ante: market quickly reports all quotes and orders to the public
• Ex post: market quickly reports all trades to the public

Question 14

Order precedence rules

Answer 14

buy limit orders with higher prices and sell limit orders with lowest prices take precendence

Question 15

Time precedence

Answer 15

Orders ranked by arrival times

Question 16

Increase in tick size makes:

Answer 16

time precedence more important

Question 17

Price priority rule properties:

Answer 17

• gives best economic outcome from trading
• total gains are maximised
• call/periodic markets use uniform pricing rule. one price
• most continuous order driven trading systems use discriminatory pricing rule - arrange trades continuously as they arrive. Price changes as orders arrive
• some continuous order driven trading systems use derivative pricing rule (i.e. crossing networks)

Question 18

Uniform pricing rule

Answer 18

Used at market open, in many exchanges and after trading halts

All matched orders executed at same price

• maximises commission
• single clearing price may not be obvious

Question 19

Discriminatory pricing rule

Answer 19

trade price is limit price of standing limit order

Question 20

Derivative pricing rule

Answer 20

matching orders executed at prices determined elsewhere

Problems:

• price manipulation
• stale price
• well-informed traders

Question 21

Centre Point

Answer 21

offers executed at the prevailing mid-point of the national best bid and offer

• will only execute against other orders in centre point
• uses derivative pricing rule

Question 22

Four Principles Determining Price:

1. Maximum Volume

Answer 22

calculate cumulative quantities at each price and find maximum executable quantity (smaller of the cumulative buy and sell quantities at each price)

Question 23

Four Principles Determining Price:

2. Minimum Surplus

Answer 23

minumum surplus volume at each price determined in 1. Surplus is the difference between the cumulative buy and sell quantity at each price

Question 24

Four Principles Determining Price:

3. Market Pressure

Answer 24

whether market pressure of the potential auction prices exist on the buy or sell side
+ sign: buy side pressure
- sign: sell side pressure
Highest of these prices is the oprning price

Question 25

Four Principles Determining Price:

4. Reference Price

Answer 25

Establishes possible prices by comparing the range of prices in 3. with reference price