market microstructure bid-ask spreads and pin daniel sungyeon kim
TRANSCRIPT
Market Microstructure
Bid-Ask Spreads and PIN
Daniel Sungyeon Kim
Bid-Ask spread
• The bid-ask spread can be decomposed
into what two components? • Adverse selection component
• Transaction cost component
Four-way Decomposition of the spread
• Adverse selection component• Transaction cost component can be further
decomposed into three pieces:– Inventory risk component – compensates dealers for bearing
price risk their inventory– Order processing cost component – compensates dealers for
their normal cost of doing business– Monopoly profits component – extra profits that can be
extracted by monopoly power
Four-way Decomposition of the spread
• Recent estimate by Henker and Martens:• Adverse selection = 15% of spread = 1.0 cents• Inventory risk = 17% of spread = 1.2 cents• Order processing = 65% of spread = 4.5 cents• Monopoly profits = 3% of spread = 0.2 cents
Total spread = 6.9 cents
Explanations for Adverse Selection Comp.
• What are the two explanations for adverse selection component?
• Information perspective
• Accounting perspective
Figure 14-1
• Ask0 = V0 + (1/2) Adv Selection + (1/2) Transaction Cost
• Bid0 = V0 – (1/2) Adv Selection – (1/2) Transaction Cost
• Figure directly shows information perspective:– If buy trade, value increases from – If sell trade, value decreases from
0 0BV V
0 0SV V
Figure 14-2
• Suppose there is a buy trade, value increases from• This becomes the new midpoint:• Ask1 = V1 + (1/2) Adv Selection + (1/2) Transaction Cost
• Bid1 = V1 – (1/2) Adv Selection – (1/2) Transaction Cost
• If next trade = buy, value increases from • If next trade = sell, value decreases from• Change in value = V1 –V0 = (1/2) Adv Selection
• Adverse Selection = Permanent Component of the spread• Vs. Transaction Cost=Transitory Component of the spread• That is, Ask0 - went away did not become part of
change in value• If the market is Efficient = reflects all available info,• then value changes are unpredictable = Random Walk
0 0BV V
1 0BV V
1 1BV V
1 1SV V
0BV
“Most Important Lesson in this Book for Most Readers”• Uninformed traders lose to informed trader regardless
of whether they use a limit order or market order• Example: Ask = 30.10, Bid = 30.00, informed have good
news that stock is worth 35.00
(1) Uninformed submits limit sell at 30.10
informed buys at 30.10, price rises to 35.00
uninformed sold at 30.10 & missed price rise
(2) Uninformed submits limit buy at 30.00
informed submits limit buy at 30.01 (or buys at 30.10)
price rises to 35.00
uninformed limit buy doesn’t execute & misses price rise
(3) Uninformed submits market buy or market sell
pays the spread, which is wider due to adv select comp
Easley, Keifer, O’Hara, and Paperman
• Develop a simple, classic model of adverse selection• Can estimate how much informed trading in any stock• PIN = Probability of INformed trade
= % of traders that are informed
PIN Computation
• Chance of Informed Sell =
• Chance of Informed Buy =
• Chance of Informed Trade =
• Chance of Uninformed Trade=
• PIN = % of traders that are informed
1
1
Buys+ Sells 2
Chance of Informed Trade
Chance of Informed Trade + Chance of Uninformed Trade
2
A PIN example
Day Buys Sells1 53 492 74 513 48 784 51 50
PIN Model Dynamics
• Some traders are informed and others are uninformed• Trading is anonymous• Market makers don’t know which
trader is informed vs. uninformed• Every trade causes a price reaction• Every sell causes a lower bid and ask• Every buy causes a higher bid and ask
= PIN
PIN Sampler
• Vega • PIN parameters
year-by-year
e m
a d
PIN
PIN Sampler
• Agudelo• In Indonesia,
who is more
informed:
foreigners
or locals• PIN(foreigners)
vs. PIN(locals)
PIN Sampler
• Easley,
Engle,
O’Hara,
Wu• Dynamic PIN
model• PIN estimates
for 16 stocks
PIN Sampler
• Easley,
De Prado,
O’Hara• Modified
Version of
PIN =
VPIN
during for
the 2010
Flash
Crash