Lecture 4 Secondary Equity Markets - II

Order Driven Markets Call Auction: how does the market aggregate information? Beliefs versus Opinions. Limit Order Book: who provides execution immediacy? Hybrid Markets.

Call Auctions: Opinions Many opinions exist in the market place. Each person conditions his demand for security on his own opinion, and on the price. Markets clear and the resulting price represents the weighted diversity of opinions of the participants. This is no different from the differing tastes for shoes or cars determining their prices.

Simple Model of Informed Trading

Demand for a Stock: Opinions 0 Number of Shares Price of the Stock D

Call Auctions: Beliefs The same as before, however now you would like to know the opinions of others to better estimate the true value. In this case you have two pieces of information: your own noisy signal, and the aggregate signal - the price. Better use it in your decisions.

What is different? Security price has another function, which is missing from the price of dresses - information. High prices increase the attractiveness of the stock, while low prices decrease it. Decline in variance increases the attractiveness.

Demand for a Stock: Beliefs 0 Number of Shares Price of the Stock D D* Price is a negative signal Price is a positive signal

Information Aggregation Market price contains the aggregation of everybodys opinions. If you believe that others opinions are relevant, then you need to rely heavily on the price. If not, then place your bets...

Limit Order Book – A Simple Model No intermediaries Traders can submit market or limit orders: fully strategic behavior. Market order demands liquidity and pay for it. Limit order supplies liquidity, but pays the cost of delay in execution. Traders differ in their level of patience.

Digression into the model.

Equilibrium strategies – majority of patient traders BA

Equilibrium strategies – majority of impatient traders BA

Results Patient traders submit limit orders, impatient - market orders. Order submission strategy depends on the rate of arrival of traders (fast versus slow markets), traders impatience, and the tick size. Different intuitions from the dealer market models.

Who Uses Limit/Market Orders Keim and Madhavan (1997): Technical Investors (prefer immediacy) – 97% market orders; Value Investors (prefer price) – 77% market order. Tkach and Kandel (2005): the effects of immediacy, time of day, day of the week effects, arrival rate of the traders, and the spread. Corroborate the model.

Limit Order as an Option - I A limit order gives an option to trade against it. We know that the option value increases in volatility. There are two types of volatilities – one is conducive to limit orders, one is not. The first type is when prices are mean reversing – no informational events. This is the best environment for LIMIT orders – ensures almost sure and speedy execution. This is the type of volatility present in the model above.

Limit Order as an Option - II If the fundamentals change once in a while, this is the bad volatility for limit orders. An outstanding limit order (a buy) suffers a loss when: –The fundamental value rises, the limit order is left unexecuted. –The value declines, the order is executed, but you may not want it to be. These considerations affect the order submission strategy and cause traders to monitor markets, and to engage in active order submission strategies.

Strategies Passive order submission. Active order management: –Pre-submission management; –Partitions into sub-orders within and across venues. –Cancellations when markets move away; –Resubmissions. Passive strategy may be well suited for small orders, but could have disastrous consequences for large ones.

Hybrid Markets Very few pure markets exist in the pure forms described above. Most markets combine the forms in various trading sessions. Examples. –US models. –European consensus. –Emergence of new competitors.

Exercise III You are a trader for a large pension fund, which follows a passive asset allocation strategy. Your investment committee had just decided on changing the asset allocation, and you have to execute the trades. Which venue would you prefer? Which orders will you use and why? Explain briefly. You are a trader at a hedge fund. Which orders do you use and why? Explain briefly.