Slides for Opening a Financial Market (Introduction)
Transcript of Slides for Opening a Financial Market (Introduction)
1
How to Open a Financial Market when Institutional Traders are
Present
Michael S. Pagano
Villanova University
2
Is trading this simple? …
3
or slightly more difficult ??
4
What Motivates Trading?
1. New information (news)
2. Liquidity needs
3. Divergent expectations (people agree to disagree)
4. Technical (noise) trading
5
Fundamental Financing Channels
Firm Investor
Firm InvestorIB / CB
Buyer Seller
Agent
Exchange
or Market Maker
Agent
6
Purposes of Financial Markets
• Set Prices for financial assets
• Exchange Information
• Raise Capital for Issuers (Primary Mkt)
• Liquidity for Investors (Secondary Mkt)
• Vehicle for Managing Risk
7
Major Trading Issues
• Liquidity
• Price & Quantity Discovery
• Volatility
• Transaction Costs
• Trading Profits for Market Makers
• Net Investment Returns
8
Order Revelation in a Financial Market
“Bookbuilding” is the process of:– revealing orders and/or trades, – forming an active market with numerous
traders, – discovering the asset’s price (price
discovery), and– deepening the order “book” and/or building
trading volume (quantity discovery).
9
Challenges of Order Revelation
• It is not a simple process.• Existence of an order is information that
can be used against the trader submitting the order (i.e., it is like a “free” option given to other traders).
• Adverse price changes can occur due to:– Market Impact of large orders,
– Front-running, and
– Mis-pricing of early orders.
10
Challenges for Large Traders
• Large, institutional traders know that their actions can impact market prices.
• Large traders are more likely to suffer “ex post” regret about their trades.
• Therefore, many large traders do not fully reveal their order sizes, thus creating strong, latent demand to buy and/or sell.
11
A Two-Sided Market with Unequal Orders
12
“Most Inefficient” Outcome via Order Shading
13
“Most Efficient” Outcome via Open Book
14
Building to an Efficient Outcome with Multiple Orders
15
The Iceberg of Transaction Costs
Source: Plexus Group, 2003
Commission 5 ¢ (17 bp)
ImpactImpact10 ¢ (34 bp)10 ¢ (34 bp)
Delay23 ¢ (77 bp)
Missed Trades9 ¢ (29 bp)
Trading Mechanism
Informed
Is p*>offeror p*<bid?
Orders Come from 3 Types of Traders
LiquidityOrder Flow
Quotes,Prices,Volume
Technical Trading
Is there a trend/pattern?
P*
Do the informedTraders agree with
each other? maybe not!
18
$21.00
$22.00
$23.00
$24.00
$25.00
$26.00
$27.00
$28.00
Ask
Bid
P*
Day 1 Day 2
De-Briefing: P*, Best Bid and Offer Quotes, and Price Impact
19
Key Questions
• How did you do in terms of achieving your goal? (e.g., did you get the shares at a “good” price?)
• What types of orders / trading strategies worked best? Which worked worst?
• What do you think caused the bid-ask prices to diverge from the equilibrium P* values?
• Did you shade your orders or did you feel comfortable submitting large orders?