ECON3050A
Lecture2
00:0023:59 IntroductiontoFinancialEconomics Lecture2 TheAssetMarketMicrostructure Wehadpreviouslyarguedthatthemarketpriceofanassetwasdeterminedbyinvestorswillingtoholdthe existingstockofanassetintotali.e.itstotalsupply. Analternativeapproachtoassetpricedeterminationistoconsidertheflowofassetpurchasesequaltotheflow ofsalesoveragiventimeinterval. Thisimpliesthatthetotaldemandbyinvestorswhowishtoincreasetheirholdingsofthisassetequalsthetotal supplybyinvestorswhowanttoreducetheirholdings. WestartbyconsideringthefunctionsandparticipantsofFinancialMarkets. WhatisaMarket? Itisasetofarrangementsthatallowsparticipantstoreachvoluntaryagreements.Wewoulddefine; Asetofarrangements thatincludinglargelyunorganizedmarketse.g.foreignexchangemarkets alsoincludeshighlyorganizedmarketssuchasFutureMarkets Agreements maybeformalorinformalcontracts theyarevoluntarywiththeimplicationthatthesanctionsofthelawcan beinvokedtoensurecompliance. FunctionsPerformedbyMarkets 1.SpreadinformationtopromotePriceDiscoveryi.e.pricesatwhichtradescanbemade. 2.ProvidesaTradingMechanismthatmakespossibleagreementstotakeplace.Thiswouldincludebuyers beingabletocommunicatewithsellers. 3.Enablestheexecutionofagreementsi.e.thereisacontractsettlementfunctionthatensuresthattermsof theagreementarehonored,and (i)confirmstransactions (ii)clearsthetradei.e.newownershipisregistered (iii)thereisasettlementofaccounti.e.moneypayment.
FinancialExchangesareassociatedwithadesignatedClearingHousethatsupervisesandadministers proceduresforcontractsettlementandthesafecustodyofassets. Themarketfunctionsareperformedbyitsparticipants.Inadditiontoauthoritiesthatregulatemarkets,thereare 3broadgroups; 1.PublicInvestorsowntheassetsandaremotivatedbyreturnfromholdingassets.Theyareindividuals, trusts,pensionfunds,otherinstitutions. 2.Brokersactasagentsforpublicinvestorsandaremotivatedbycommissionfeesforservices,donottrade ontheirownaccount,butforothers. 3.Dealersdotradefortheirownaccount,makeaprofitthere,notfromholdingtheasset.Theymakeaprofit fromthedifferenceinthebid/askpricei.e.thespread. Theyarenotmutuallyexclusive;brokersmayactasdealersaswellasholdassetsoftheirown.Also,inmany marketstherearedesignateddealerswhoensurethatthetradingmechanismfunctionssmoothlytheyactas marketmakers.Inreturntheyaregrantedprivilegedaccesstomarketinformation. Inthe1990swiththeemergenceofelectroniccommunicationnetworks,exchangeslargelyreplacedthis processbyadoptingthenewtechnology. TradingMechanisms Theyfallinto2categories;(1)quotedriven(2)orderdrivenmarkets.Thesemarketsnowoverlap.Lets considerthemseparately. QuoteDrivenMarkets(dealermarkets) Dealerquotebidandaskpricesatwhichtheyarepreparedtobuyandsellspecificquantitiesofasasset (stock).NASDAQisaquotedrivenmarket. (1)Thesemarketsneedmechanismstomakeavailabledealerspricequotes. (2)Regulatetheconductofdealers (3)Administerthesettlementofcontracts InNewYorkitsNASDAQ,inLondonitstheSEAQsystem,inTorontoitstheTSE.Dealersmustadheretothe marketauthoritysrules.Bidandaskpricesmustbefirmpricesuptoaspecifiedvolume.
ConsiderFig.2.1onpage37Flowdemandandsupplyforasingleasset.Thisisdistinctfromthestock demandandsupplyfunctionsofFig.1.1whichexpressthepreferencestoholdanasset.Herethebuyerpays
theaskpriceandthesellerreceivesthebidprice.Thedealerreceivesthespreadbetweenthe2prices. Note: differentdealersmayofferdifferentbidaskspreads tradestakeplacesequentiallyi.e.theobservedtransactionpricedependsonwhetherasaleorpurchasehas takenplace. dealersmayalsonegotiatespecialpricesforlargetransactionsathighestbidoraskprice(mostfavorable priceforcustomer). OrderDrivenMarkets(AuctionMarkets) Marketparticipantsissuesorderstobuynorsellatastatedprice.Thepriceisthenadjustedbytheauctioneer untiltotalorderstobuyequaltotalorderstoselli.e.findthemarketclearingprice.Thissearchingprocess approximatestheWalrasiantatonnementprocessi.e.groupingforaclearingprice. AnExampleLondonGoldFixingPrice: Twotimesaday,5bulliondealersmeetinRothschildsBanksFixingRoom.Thechaircallsoutastartingprice. Afterconsultingwiththeirofficesviaphone,thedealersreporttheirnetpurchasesorsalesatthatprice. Chairmanaddsupsalesatthatprice.Iftradesdonotbalance,hecallsoutanewprice.Processcontinuesuntil alldealersacceptthenewprice.Thisisacallmarketprocess.Itisalsoadiscreetprocesssincethepriceis determinedalimitednumberoftimesaday. ThisprocessalsoappliestoUStreasurybillsandbonds,sometimestonewshareissues.Inrecentyears, continuoustradingsystemsforsecuritieshavereplacedmanycallmarkets. Incontinuousauctionmarkets,investorsdirecttheirorderstobrokerstobuyorsell.Therearemanydifferent kindoforders.Bestknown; Limitorderstobuyorsellasetnumberofsharesataspecificpriceorbetter.Investorscanalsolimitthe lengthoftimetheordercanbeoutstandingbeforeitiscancelled.Suchordersaregoodforlowvolumeor highlyvolatilestocks.Getsthebrokerahighercommission.
Marketorderstobuyorsellastockimmediatelyatthebestavailableprice.Theseareunrestrictedorders usefulforhighvolumestockswerethespreadbetweenaskandbidpricesaresmall. Bothtypesofordersareknownaspublicordersi.e.fromoutsidetheexchange.Notethatoutstandinglimit ordersaregenerallylistedinalimitorderbook.
Automatedtradeexecutionsystemsnowtakecareofallofthis.ItusedtobethatattheNYSEandTSE, specialistswererequiredtobuyandsellsuchsharesandcoulddealasprinciplesontheirownbehalf.This alwaysensuredapriceatwhichtradingcouldtakeplace.Theprocessusedtobeanopenoutcrysystemin whichfloortradersshoutedordersandcommunicatedamongthemselvesinatradingpitusinghandsignals. Nowtherearemostlyelectronictradingmechanisms.Still,theCBOTChicagoBoardofTrade,workstheold fashionedwayinsomeproductareas. ComparingQuoteDrivenandOrderDrivenMarkets Considerliquidityandtransparency Aliquidmarketisacontinuousmarket.Anyamountofstockcanbeboughtorsoldimmediately.Suchamarket isalsoanefficientmarket.Smallorlargequantitiesofstockcanbeboughtorsoldatanytime,verynearthe currentmarketprice.Amarketisonlyilliquidifthereisnoresponsetoanoffertobuy/sellaquantityofstockat thecurrentprice. Transparencyisthedegreetowhichinvestorscanobserverecenttrades.Thisisimportantbecausesuch informationisrelevanttoforecastingfuturepricesandwhetheratradewouldbeexecutedatthereportedprice. Inprinciple,bothquoteandorderdrivenmarketsshouldresultinthesamemarketpriceifalltradesinastock aremadepublic.However,quotedrivenmarketstendtobemorefragmentedbecause(i)differentdealers quotedifferentbid/askpricesand,(ii)someexecuteddealsdonotbecomepublicinformationimmediately,but arepublishedwithadelay. Orderdrivenmarketstendtobemoretransparentandtheexistenceofalimitorderbooktendstomakethe marketlessfragmentedsinceitsavailabletopublicview,forexampletheconsolidationtapeinNewYork providesinformationaboutpriceandquantitytraded.
Nevertheless,investorsmayprefertheopportunitytonegotiatewithdealersinquotedrivenmarkets,especially ifthedealinvolvedalargeblockofshares.Notonlywouldtheybeabletogetagooddealfromthedealerand therewouldbeatleasttemporaryprivacybecauseofadelayinpublishing. Areliquidityandtransparencyalwaysdesirable? Liquiditymightbebeneficialforanyindividualinvestor,but,becauseofitsconsequencesforassetprice fluctuations,costlyforinvestorsingeneral.Itraisestheissueofprivateversussocialbenefits.However, restrictingliquiditywoulddeterwealthholdersfromholdingliquidassetswhichwouldaffectproductive investments.Asfarasmarkettransparencyisconcerned,visibilityoftermsandconditionsofalltransactions maydetersometrades.
IndustrialOrganizationofFinancialMarkets ControlofMarketInstitutions Whileforeignexchangemarketsareaninformalnetworkofbanksandotherfinancialcompanies,thereare moreformallyconstitutedexchanges. 1.MutuallyOwnedCooperativestheyarecontrolledandmanagedbyitsmembers.Itcontrols;(i)market facilitiesi.e.computernetworks,dedicatedphonelines(ii)itwritesthemarketrulebookforitsmembersand administersit.(iii)Itsmembershipconsistsofdealers,brokersandpublicinvestors. 2.ShareholderOwnedCompaniestheyarelegallydistinctfrommarketparticipants.Itownsandoperatesthe exchange.Sharescanbeprivatelyheld,ownedbythestate.Asapubliccompany,sharescouldbetraded. Membersmaywhollyorinpartowntheshares. MostFinancialExchangesstartedlifeasMutuallyOwnedCompaniesTSE,NYSE,NASDAQ,LSE,CBOT. Inthelate1990stheytransformedthemselvesintoshareholdercompanies,followedbymergersand takeovers.Thisreflectsthechangesbroughtaboutbyadvancesininformationtechnologyi.e.reducedcostof sharetrading,greatercompetitionandglobalizationthathaspromotedinternationalcapitalflows.Exchanges havemovedfromhighlyregulatedorganizationwithmonopolypowertofirmsthatfacecompetitionforthe servicestheyoffer.
Shoulditmakeanydifference? 1.MutuallyOwnedCooperativesaretheoldfashionedwayoftrading. Theyoperatedintheinterestofexistingmembersorasubsetofmembers. Itwasusefulwhenownersarealsocustomers(dealers,brokers).Theywereabletorewardexistingmembers by(i)restrictingmembership(ii)favoronegroupofmembersoveranother(iii)discriminateagainstothermarket participants.Theyalsoresistedinnovation. 2.ShareholderownedCompanies Motivatedbyprofit,madebychargingfeesforuseofmarketfacilities. Theyarelessanxiousabouteffectsoftechnologyandfinancialinnovations Theyarelesslikelytorestraincompetitionamongmemberandnonmemberfirms. Theyencouragecompetitionifitresultsingreatertradingvolumeandprofitsfortheirshareholders.
Ofcourse,thenatureandextentofcompetitionisaffectedbyregulations. Theseareverycomplexexchangesthemselvesarepartoftheregulatorymechanism.InCanada,the RegulationsofFinancialMarkets regulationsaremanagedbytheInvestmentCanadaAct,administeredbyIndustryCanada.IntheUS,the SecurityandExchangeCommission(SEC).IntheUK,theFinancialServicesAuthority(FSA). Theprotectinvestorsfrompracticesandconductthatisseenasunfairorisfraudulent. Theyencouragecompetitiontobenefitinvestors. Manyoftheregulationsinfinancialmarketsareoftheselfregulatingkind. CompetitionWithinandAmongFinancialMarkets Investorscantakeassetpricesasgiven,andbeingbeyondtheircontrol.However,brokersanddealer servicesmayoffernonpricecompetitiveelementstopromotethemselvesi.e.markettheirservices.
Exchangesandtheirregulationscanhavetheeffectofrestrictingcompetitionamongmarketparticipants. 1.membersmustoftenprovidecapitalasaguaranteeagainstdefaultorfraud.Itcanbeconsideredthecostof doingbusiness,butitcanalsobeusedtolimitthenumberofmembers,thusreducingcompetition. 2.Exchangesappointindividualmarketspecialiststotradeinspecificsecuritiesfortheirownaccount(market makers).Thismonopolypowerisgiventothembecauseoftheirobligationtoquotefirmpricesguaranteedfor tradewithothermarketparticipants. 3.Membersofanexchangemayberestrictedintheirtradingactivityoutsideoftheexchange. Thereissomeevidencethatdealershavecolludedregardingassetpricing.Seepp4445. TradingandAssetPricesinaCallMarket Modelingtheflowoftradinginanassetmarket: a)marketparticipantsaredividedinto3groups:(i)informedinvestors(ii)uninformedinvestors(noisetraders) (iii)marketmakers. b)investors(i)and(ii)arepublicinvestors.Marketmakersexisttoensureapricethatbalancespurchasesand salesbypublicinvestors. c)All3participantsareassumedtoberiskneutral. Theexchangeofassetstakesplacefor2reasons;
aninformationmotiveinvestorsseektomakeaprofit(avoidaloss)basedonthebeliefaboutfuturepayoffs. Liquiditymotiveraisefundsforconsumption,meetfinancialobligations,orinvestsavings. Bothmotivesareattributedtotheuninformedinvestorwhoseactionsarerandomandexogenous.Thetotal amounttraded,U,bytheuninformedinvestorisassumedtobeanormallydistributedrandomvariablewith Expectationsof(u)=0andthevariance=2(u).ThenU=N(0,2(u)).UandVareusedtolabelrandom variableswhileuandvdenotetherespectiveoutcomes.
Itisassumedthatthereisoneinformedinvestorwhoactstoprofitfrominformationaboutthepriceoftheasset. (info.isimperfect)BoththemarketmakerandtheinformedinvestorbelievethatthevalueoftheassetV,is determinedbyanormaldistribution,withexpectationvandvariance,Var(v)suchthatV=N(v,Var(v)).The informedinvestorhasknowledgeoftheoutcomev,notjustknowledgeofthedistribution. Marketmakersdonotobservethepriceoutcomev,butdoobservetheaggregatetrade,yofinformedand uninformedinvestors. Neithermarketmakersnortheinformedinvestorobservetheamounttradedbyuninformedinvestors,butboth knowthedistributionfromwhichitisdrawn. Marketmakersareassumedtobecompetitivei.e.thepricechosentomaximizeexpectedprofits(conditional ony)issuchthatthelevelofexpectedprofitiszerothehighestthatcanbeachieved. Stepsinpriceformationare: Informedtraderlearnsv,theoutcome,andchoosesanamountofassetstotrade,x,tomaximizeexpected profits. Tradebytheuninformedinvestors,u,isdeterminedrandomlyfromN(0,Var(u)) 1.Onreceiptofmarketorders,marketmakersareseeingy=x+u,settheprice. Kyle(1985)showsthatthemarketprice,p(y)andtheamounttradedbyinformedtrader,x(v)aregivenby, P(y)=v+2(v/u)yandx(v)=(u/v)(vv) Marketmakersobservey,butcannotobserveuandxseparately,sothattheequilibriumpricedependsony alone. Insightsfromthemodel:
1.Itshowshowasymmetricinformationcangeneratetradeandhowmarketmakerscansetpricesto equilibratethemarketeventhoughtheyhavelessinformationthentheinformedinvestor(theyonlyknowy).
2.Assumethattheinformedtraderisimportantbecausev,theoutcomeislargerelativetou. 3.Ifmarketmakersobservealarge,positivey,thepricewillrisesignificantlyabovevbecausethemarket makerassumesthattheinformedtraderhasinformationthatvishighandthereforesetsthepricehigherto avoidlosses. 4.Buttheinformedtraderknowsthattheuninformedtradersdontvarytrademuch(smallu).Therefore, whenvisknowntobehigh,theinformedtraderlimitsthesizeofx(v),otherwisethemarketmakerwouldraise thepriceabovethelevelthatwouldmaximizehisexpectedprofit. 5.Alternatively,supposeuninformedtradersareimportantbecausetheirtradesvaryaloti.e.u>>>v.Now pricevarieslesswithrespecttototaltradeybecausethemarketmakerrecognizesthatmostofthevariations intradecomefromtherandomfluctuationsinuninformedinvestorstrades.Theinformedtraderwillnowissue ahighdemandforx(v)becausethemarketmakernowhasdifficultyindistinguishinghimfromtheuninformed traderssincethemarketmakeronlyseesy. Themodelcanbeinterpretedasatheoryofinsiderdealingwiththeinformedinvestorastheinsider. Nevertheless,theassetmarketisefficientsincethemarketpriceequalstheexpectationsofVconditionalony. BidAskSpreads:inventorybasedmodelsvs.informationbasedmodels Bothmodelsassumethat; Therearemarketmakersandpublicinvestors Marketmakersareassumedtobedealerswhoquotebidandaskpricesatwhichtheyguaranteetobuyand selltheassetuptoagivenvolume. Publicinvestorsareinformedanduninformedinvestors. Modelsignoredealerswhoarenotmarketmakers. Brokerageservicesarenottreatedseparatelyfromthoseofmarketmakers.Thebidaskspreadtherefore includesalltransactioncostscommissionsplustaxes. Investorsareassumedtoarriveatmarketinarandomflowandissueorderstobuy/selloneunitoftheasset, executedattheask/bidpricerespectively.Pricequotesarethenchangedaccordingtoarulebasedonbid/ask orders. Inventorybasedmodelsseethepricequotationsasdeterminedbytheneedofthemarketmakerstohold inventoriesofassetstosatisfytheflowofthedemandandsupplyfrompublicinvestors.Therefore,thebid askpricespreadisbasedon:
1.Thecostofholdinginventorythereisanopportunitycostbecausefundscouldbeinvestedelsewhere. 2.MarketPowerSincecompetitionamongmarketmakersistosomeextentrestrictedwhichimpliesthatbid pricesarelowerandaskpriceshigherthenotherwise. 3.RiskAversionMarketMakershaveitbecauseoftheirobligationstoauthoritiesthereforeavoidingholding zeroinventory. PredictionsoftheInventoryModel Transactionpricesatwhichtradestakeplacearesuchthattheirdifferences Pt+1,Pt+2arenegativelycorrelatedi.e.increasesinpricesarefollowedbyfallsinprices,andvice versa. Thesizeofthebid/askspreadisadecreasingfunctionofinventoryvolumei.e.thelargertheinventory,the smallerthespread. TheInformationbasedModelofPriceDetermination 1.Assumesthatinventoriesarealwaysadequateandthecostofholdingthemisignored. 2.Theanalysisconsiders(i)asymmetryofinformationbetweeninformedanduninformedinvestors(ii)market makers,itisassumes,cannotobserveiforderscomefrominformedoruninformedinvestors. 3.Itisassumedthateachmarketmaker(i)haszerotransactioncosts(ii)isriskneutral(iii)hasnomarket power. 4.Theremaybemanyinformedinvestorsandordersstillareassumedatoneunitofasset. 5.Ordersareassumedtobereceivedsequentiallyinarandomfashionfromeitherinformedoruninformed investors. Whenmarketmakersreceiveanorder,itcouldcomefromaninformedinvestorwhoknowsmorethenthe marketmaker(andprofitsathisexpense)or,itcomesfromanuninformedinvestorwhodoesnotexploit informationonthevalueoftheasset.Itfollowsthatifallinvestorswereinformedinvestors,themarketmaker couldnotsurviveandthemarketwouldcollapse.However,ifmarketmakershavesome,imperfectknowledge ofthecompositionoftheorderflow,thenthemarketcanbeviable. So,intradingwiththeinformedinvestor,eachmarketmakerwillhavealosssincethisinvestorknows somethingthathedoesntknow.Intradingwithuninformed
investors,hewouldearnzeroprofitsifthebidpriceequalstheaskprice.However,
iftheyquoteaskpricesgreaterthenbidprices,themarketmakerscan,onaveragemakeaprofit.This expectedprofitoffsetstheexpectedlossfromtradingwithinformedinvestors.Competitionamongmarket makersensuresthatonaveragetheybreakeven. Learning Thiscanbebuiltintotheevolutionofpricessincetheorderstobuyorsellcontainpartialinformationaboutthe valueoftheassetthatthemarketmakerexploitsbyrevisingtheirbidandaskpricesovertime. BayesLawupdatedbeliefsformthepriorbeliefsatthenexttradingdate. Implications 1.Thetransactionpricefollowsamartingale(asequenceofrandomvariablessuchthattheconditional expectedvalueofanobservationattimet,isequaltotheobservationatanearliertimeswhichistheresultof asetofearlierobservationsons. 2.Given(i)informedinvestorsknowtheprobabilitydistributionoftheassetsvalueand(ii)themarketmakers beliefsareupdatedaccordingtoBayesLaw,hisbeliefswilleventuallyconvergetotheprobabilitydistributionof theassetsvalue.Tradingwilleventuallyrevealthetruthi.e.theprobabilitiesassociatedwitheachpossible assetvaluebecomesknowntothemarketmakerandarethereforereflectedinthemarketprice. 3.Themarketcanfailifthemarketmakersetsthebidaskspreadtoowidefortradestotakeplace.Thiscould occuriftherearetoomanyinformedinvestorsrelativetouninformedinvestors. 4.Ifthedealeralwaysloseswhendealingwithaninformedinvestor,thenthebidaskspreadrequiredtobreak even,maybesolargethatnobodywantstotrade. Modelneedssomeextensions: 1.Modelcanallowinvestorstochoosehowmanyunitstheymaywanttotrade. 2.Informedinvestorstakeintoaccounttheeffectoftheiractionsonprice. 3.Uninformedinvestorspossiblychoosethetimingoftheirtradestopartiallybenefitsfromtheinformation revealedbythetradesoftheinformedinvestor.