O allows investment to flow to best uses allocation

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o allows investment to flow to best uses. allocation of capital is v important. also, v important bc it finances gov. and households very important for industries that are expanding rapidly or investing heavily in new tech. for such industries, internal funds are not enough. for new firms and new industries, must rely on external financing bc they do not have internal funds. *this is v important: this is how the economy grows!!* 4. What is an “ideal” financial market? Explain how a market’s liquidity and trading costs affect whether it is or is not “ideal”. in ideal market: trades take place at fair prices. prices change immediately to reflect any new information so no one ever buys/sells security for more/less than fair price. (fair price- best deal you can get with what you know about the deal) in a market w good liquidity, o market price should not fluctuate in response to a liquidity imbalance. o fair price of security depends on well informed assessment of value of promised future payments – temporarily liquidity imbalance should not affect this assessment and not affect market price. o if market price does fluctuate in response to a liquidity imbalance, then the market price is not “fair” and market is not ideal. o if there is liquidity imbalance, market price would not equal fair price so market is not ideal. ideal market has minimized trading costs so traders can offer fair prices (for example, trading costs may be passed onto investors in form of a higher asked price) 6. What effect do information traders have on dealer markets? On auction markets? Information traders are traders who profit from discrepancies between the market price and the fair price. Likely to be a trader if you’re well-informed in the market Dealer market: a market made by dealers, who quote prices at which they are willing to buy and sell
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o gives dealers a strong incentive to set prices accurately. Also, gives dealers an incentive to hoard information about the volume of buy and sell orders and the prices of these transactions. o info traders can make money in these markets bc dealer is typically slow in adjusting his prices to new info. o customers like info traders bc they keep dealers on their toes. yes, info traders may cause dealers to increase their spreads which customers don’t like, but competition prevents dealers from increasing spreads a lot. Auction market: a market in which the orders of traders are matched directly o The information traders provide liquidity. o Information traders take advantage of securities that are priced far away from its fair price because of a liquidity imbalance. o Auction markets make information available as quickly as possible so it’s easier for information traders to smooth out liquidity balances.
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