financial markets, institutions, and the trading environmentslide 1 financial markets, institutions,...

Financial Markets, Institutions, and the Trading Environment

Financial Markets, Institutions, & the Trading Environment (MSF 8610)

Dr. Michael Pagano, CFA

Adapted and Excerpted from Slides by:

Dr. Robert Schwartz © 2004Baruch College

and Wayne Wagner

President, Plexus Group


Objectives

Understand: How markets operate from the perspective of the users (investors, dealers, and other intermediaries) How prices are set and trades made in different market places That price determination and quantity discovery are complex processes That prices are volatile intra-day


Goal of a Trading System

Bring customer orders together to make trades: At reasonable cost In a timely fashion At reasonable prices

Success depends on quality of a market’s structure: The systems, rules and protocols that determine how orders are handled and transformed into trades


Costs

1. Definition:

• Explicit costs of trading: commissions, taxes, etc.

• Implicit costs of trading– Transaction costs other than commissions and taxes

2. Execution Costs• Bid-ask spread

• Market impact

• Opportunity cost


3. Effects

• Reduced portfolio returns (can result from all of these costs)

• Inflated short-period price volatility (due to bid-ask “bounce,” market impact, price discovery)

Costs (cont.)


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)


Cost Components

• Total Cost = Commission + Impact (intra-day)

+ Delay (inter-day) approx. 157 bps

(one-way) 314 bps (round-

trip!)

• What is the cumulative impact on a 10% annual return over: 1, 5, and 10-year horizons?


Total Cost

Total Cost of Trading

0

50

100

150

200

250

Bas

is P

oin

ts

NASDAQ

NYSE

NASDAQ 43 71 85 134 230

NYSE 43 56 81 94 138

Giant Cap

Large Cap

Mid Cap

Small Cap

Micro Cap


Commissions

Commission Cost

0

25

50

75

100

125

150

Bas

is P

oint

s

NASDAQ

NYSE

NASDAQ 16 15 22 29 50

NYSE 12 15 20 26 39

Giant Cap Large Cap Mid CapSmall Cap

Micro Cap


Impact

Impact Cost

0

25

50

75

100

125

150

Bas

is P

oint

s

NASDAQ

NYSE

NASDAQ 16 28 33 37 42

NYSE 18 19 25 23 20

Giant Cap Large Cap Mid Cap Small Cap MicroCap


Inter-day Delay

Delay Cost

0

25

50

75

100

125

150

Ba

sis

Po

ints

NASDAQ

NYSE

NASDAQ 10 27 30 67 137

NYSE 13 22 37 46 79

Giant Cap

Large Cap

Mid CapSmall Cap

MicroCap


Trading Mechanism

3 Sources of Orders

Informed

Is p*>offeror p*<bid?

What Drives a Market?

LiquidityOrder Flow

Quotes,Prices,Volume

Technical Trading

Is there a trend/pattern?

P*


The Big Problem

Enabling Buyers and Sellers, Large and Small, to Find Each Other

Two Dimensions Place Time


10:50 10:55 11:00

PublicBuyer

PublicSeller

LimitOrder

Executes

Placesa BuyLimit

Order

Order Driven Market

The limit order book brings

buyer& seller together

The limit order book brings

buyer& seller together


BIDS PRICE OFFERS

11.30 91

11.25 0

11.20 52

11.15 24

11.10 7

11.05

11.00

35 10.95

70 10.90

0 10.85

20 10.80

67 10.75

39 10.70

46 10.65

The Limit Order Book

Bid – Ask Spread(10.95 - 11.10)

Air Pocket

Air Pocket


10:50 10:55 11:00

PublicBuyer

PublicSeller

DealerBuys

DealerSells

Dealer Intermediation

Dealer provisionof immediacybrings buyer

& seller together


View From a Market Maker’s Desk

Dealer Bid Dealer Ask

COD 26.00 CAT 26.20

DOG 26.00 COD 26.30

TUNA 25.90 DOG 26.30

CAT 24.80 TUNA 26.30


Order Driven Market

Best Ask 100 shs @ $20.00

Best Bid 200 shs @ $10.00

<Last sale $15


Best Public Ask 100 shs @ $20.00

Best Public Bid 200 shs @ $10.00

< Mkt order: Sell 100

< Sold @ $10

< #*@$%**

<Last sale $15

Thin Order Book


Dealer/Specialist “Makes” the Market



<Last sale $15Specialist Ask 100 shs @ $15.05

Specialist Bid 100 shs @ $14.95


Public Trades with Dealer



< Mkt order: Sell 100

< Sold @ $14.95

<

<Last sale $15Specialist Ask 100 shs @ $15.05

Specialist Bid 100 shs @ $14.95


Dealer Is Long 100 Shares



Specialist Ask 100 shs @ $15.05

Specialist Bid 100 shs @ $14.95 $14.90


10:50 10:55 11:00

PublicBuyer

PublicSeller

A Call Auction

A meeting pointin time can bring multiple buyers &

sellers together


The Electronic Call Auction

Orders that could otherwise be matched and executed are held for a big, multilateral clearing.

Clearings are held at pre-determined points in time (i.e., once an hour).

All crossing orders are executed at a single price:

– Buy orders at that price and higher execute

– Sell orders at that price and lower execute


O

The Batching of Customer Orders

••

O

•

•O

• O•

O

51

50

49

48

47

52

Question

How should these limit ordersbe integrated to produce a good

price?

1 2 3 4 5 6 No. Orders

Price O Offer• Bid


Cumulate The Buy Orders

• (1)

• (3+1=4)

• (4+1+5)

• (5+1=6)

••

•

•

•

•51

50

49

48

47

52

1 2 3 4 5 6 No. Orders

Price

• (1+2=3)

• Individual buy order

Cumulated buy orders at the price or better


Cumulate The Sell Orders

•

•

•

•

•

O(1)

O(2)

O(3)

O(4)

O(5)

51

50

49

48

47

52

1 2 3 4 5 6 Orders

Price

• Individual sell orderO Cumulative sell orders at the price or better


Match Cumulated Buy & Sell Orders

O

O

O

O

O

CUMULATED SELL ORDERS

•

•

••

• CUMULATED BUY ORDERS

51

50

49

48

47

52

1 2 3 4 5 6 Orders

Price

3

50P* =


Price Discovery

Definition:

Finding P*, the value that best reflects the market’s underlying demand to hold shares of an asset.

Locating P* is not a simple matter!


Price Discovery

1. A dynamic process.

2. Accuracy is difficult to achieve.

3. Accuracy depends on Market Structure:

Definition: the rules, systems, and protocols that determine how orders are entered and translated into trades.

4. Also depends on the trading behavior of individual participants.


Three Other Market Characteristics

Immediacy

Liquidity

Volatility


Appendix A. Key Statistical Measures

Mean Return (via ln of Price Relative)

Variance and S.D. of Returns

Market Model Beta, R2, and Residual Variance.

Variance Ratio = Var (R0,2) / [2 * Var (R0,1)]

Volume-Weighted Average Price =

VWAP0,T = t=1,T wt * Pt

where, wt = Sharest / t=1,T Sharest


Additional Measures• Quoted Spread = (Ask – Bid)• Effective Spread = 2 * (B/S) * (Pt – Quote Midpointt)• Quote Midpoint = (Ask + Bid) / 2• Realized Spread = 2 * (B/S) * (Pt – QMPt+n)

• Tot. Trans. Cost = Delay + Impact + Missed Trades• Delay = (B/S) * (Pfirst – Porder) / Porder

• Impact = (B/S) * (Plast – Pfirst) / Porder

• Missed Trades = • (B/S) * (unfilled / total order) * [(Plast – Porder) / Porder]• Implementation Shortfall = • Beginning Portfolio Value – Ending Portfolio Value

Financial Markets, Institutions, and the Trading Environment$21.00

$22.00

$23.00

$24.00

$25.00

$26.00

$27.00

$28.00

Ask

Bid

P*

Day 1 Day 2

P* and Best Bid and Offer Quotes


Market Structures


Topic 6

Liquidity


Liquidity

CAPM, the frictionless environment

2 dimensions: risk and return

Liquidity is perfect and a stock can be traded immediately at its equilibrium value (P*)

Actual markets

3 dimensions: risk, return, and liquidity


Liquidity: What is it?

Difficult to define & measure but – You know when it’s not there

Without sufficient liquidity, a market will not function

A quick definition: Lots of orders on the book Lots of order flow


What Do the Following Have in Common?

Without Gas, Neither Will Run


Order Flow is Gas For a Market

Order Flow = Liquidity

An excellent system will not operate if it does not receive

Critical Mass Order Flow“Order flow attracts order flow”


Illiquidity

High Intra-Day Volatility

High First ½ Hour volatility

A Problem For All MarketsA Bigger Problem for Small Cap Stocks

Evidence of Illiquidity


Liquidity

Attributes of a liquid asset Breadth: orders on the book exist at an array of

prices in the close neighborhood above and below the price at which shares are currently trading.

Depth: orders are of large size. Resiliency: price changes due to temporary order

imbalances quickly attract new orders to the market, thereby restoring reasonable share values.

Frequent trading.


Liquidity

Little breadth, depth, or resiliency

Accentuated short-period price volatility

Attributes of an illiquid asset


Hierarchy of LiquidityHigher Cost Of Trading25%

PercentOf dailyvolume

Last resort

100%

Size of Trade

For hire

Hidden

Flow

Revealed

More liquidity at

higher cost

Cost


Level Of Transaction

Nature of Liquidity Provider

Type of Liquidity

Role of Market Maker

RevealedPublicly

pre-committedNatural Traffic Cop

FlowWill decide to trade in a short timeframe

Natural Traffic Cop

HiddenPrivately

Pre-committedNatural

Information-centralSecret keeper

For hireStand-by

commitment at a price

Situational(Liquidity seller)

Information-centralbush beater

Last resort Value investorNatural

(Contrarian)Traffic Cop


Building Liquidity

1. Attract Investor Attention

Stocks are not bought

They are sold


Building Liquidity

2. Develop A Good Environment Strong Regulation of Abuses of Power and

PositionFrom Trading Surveillance to Corporate

Governance Clearance and Settlement Control Volatility Nurture an Equity Culture


Building Liquidity

3. Attract Limit Orders

Commission Structure Rules of Order Execution

Strict Time and Price Priorities Tick Size


Building Liquidity

4. Role of Intermediaries

Natural vs Supplemental Liquidity Dealer Capital Animate the Market


Building Liquidity

5. Involve the Listed Companies

Natural vs Supplemental Liquidity


Building Liquidity

6. Include Call Auction Trading


Call Auction Trading

Bunch orders together for:

Simultaneous Execution In a Multilateral Trade At a Single Price At a Pre-Determined Point in Time

A POWERFUL TRADING VEHICLE


Liquidity & Random Walk

Positive Intertemporal Correlation Sequential information arrival The limit order book Market maker intervention Inaccurate price discovery

Negative Intertemporal Correlation Bid-ask spread Market impact effects Inaccurate price discovery

Serial Cross-Correlation


Market Structure Issues

Fragmentation Free riding Systemic problems Price discovery Hybrid market structures Intermediary and market center profitability Handling institutional order flow Proper identification of customer


INTRADAY VOLATILITYNYSE

October - December 1999

0.00%

0.40%

0.80%

1.20%

1.60%

Hal

f-Hou

r V

olat

ility

The First 1/2 Hour


Making the Trade

(based on Navarro chapters)


The Stock Market and Business Cycles

Stock Market is a leading economic indicator Different Sectors shine at various points during the business cycle.

Early / Middle / Late Bull Markets:Transportation / Capital Goods / Commodities

Early / Middle / Late Bear Markets:Consumer Staples / Utilities / Cons. Cyclicals


The Interest Rate Cycle & Yield Curve

Yield Curve can be a Leading indicator of both the Stock Market and Economy. Federal Reserve sets short-term rates but… Long-term rates set by investor expectations of economic growth and inflation. Bonds and Money Market instruments can be competitors to Stocks.Normal / Steep / Inverted / Flat Yield Curves:Middle Bull / New Bull / Bearish / Mixed


Managing Risk

3 Key Risks: Market, Sector, Company. Compute Reward-to-Risk Ratio for your trades / stocks:Ad hoc Rule of Thumb (3:1), Sharpe Ratio, Alpha, Beta. Diversification is very important (e.g., “no more than 20% in one sector”). “Never bet the farm!” “When in doubt, go flat.”


Managing Trade Execution

Market vs. Limit Orders Trading Range vs. Trending Markets Intelligent Stop Loss orders:

Set “loose stops” Avoid round numbers & technical nodes Use “trailing stops” to lock in gains

“Never turn a winner into a loser” “Never average down a loss” “Never churn your own portfolio”


Topic 8

Institutional Order Flow


The Eye of the Storm

The institutions are huge Markets are structured for retail order flow How can the big guys get the liquidity they need?

Dealer capital Place limit orders Trade negotiation Not held (NH) orders Slice, dice and shred

Big Pegs and Tiny Holes


Price and Quantity Discovery

Institutions avoid active participation in price discovery

Institutional and retail order flow should be integrated

Latent demand (invisible quantity)


Remarks from John Phinney

• To a retail investor, the stock exchanges look like a vending machine!

• This is not the case for the institutional trader. As we know, the “peg” of institutional trading interest is much larger than the “hole” size of the exchange process.

* Remarks made at Baruch Conference, Coping With Institutional Order Flow, NYC, April 29, 2003

*


• The “meat grinder” appears clearly in all of our data sampling.

• Trading costs seem to be much more related to endogenous market factors, structure, and process, than to exogenous factors derived from investor behavior.

Remarks from John Phinney (cont.)


Phinney’s Meat Grinder Example1.8 Million Buy Order for Oracle,

August 15, 2002

Executions Number: 1,000+ Average size: 1,700 shares Largest : 64,000 shares Smallest: 13 shares 1000 shares or less 61% of execs

100 shares or less: 17% of execs

Time to complete: 51 minutes


Phinney’s Conclusion

It required a 1,000-to-1 reduction of the manager’s intent (and a significant amount of technology) to get trade pieces small enough to be digestible by the market.

It was a DFT


Best Execution

1975 Security Acts Amendments Retail vs. institutional order flow Execution price vs

Speed Certainty Anonymity Control Etc.

An order is multi-dimensional.


What is Best Execution?

• A snapshot assessment for a single, no brainer order?

– What about orders that are sliced & diced?

– Order that are market timed?

• Beating a performance benchmark?

• Quality of procedures followed?

• None of the above?

• Best Execution is better thought of as a process.


Is it “Best” Execution That is Needed?

Not ReallyInstitutional investors want to trade at

Validated PricesConsider a PM

• Who is willing to pay up to $45 if… $45 is the price at which shares are trading

• Who pays $38 and, in a matter of minutes orhours, see trades at $36


A Validated Price

Crossing Networks VWAP Trading

Others having traded at the pricevalidates the price

No presumption that Crossing Benchmarks or VWAP are

well-discovered Prices


Impediments to Best Execution

• Soft dollar commitments

• Use of an erroneous benchmark

• Excessive pressure to trade quickly

• Imperfect market structure


Heart of the Problem

Outsourcing research, computer systems, and other support services to sell-side with client assets used as payments => Agency Problem!

(The costs are hidden)

Commission Bundling

Soft Dollars


Why?

Fund Performance is hard to assess

General lack of systematic positive correlation between past performance and current returns but…

explicit payments for research, etc. would be…

explicit

(Why make it easy?)(Why make it easy?)


Consequences

Higher trading costs

Lower investment performance

immediacy Induced demand for

financial markets, institutions, and the trading environmentslide 1 financial markets, institutions,...

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