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UvA Msc. Finance Financial Markets Full Summary (incl. All Articles and Lectures)
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UvA Msc. Finance Financial Markets Full Summary (incl. All Articles and Lectures)
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Financial Markets – Lecture Notes Week 1Players in Securities Markets
• “Buy” Side: parties who demand trading services
o Individuals (Retail investors)
o Institutions (Wholesale investors), including mutual funds, pension funds, corporates, etc.
• “Sell” Side: parties who supply trading services
o Market Makers/Dealers/Liquidity providers
▪ Quote prices at which they are willing to trade
▪ In doing so, they provide liquidity & immediacy to investors
Liquidity in the sense that it makes it easier for traders to trade (at low cost)
Immediacy as in traders do not need to wait to perform a trade (e.g. mutual fund
doesn’t need to wait for an investor to demand its positions if it wishes to liquidate,
it can sell immediately to the market makers)
▪ Marker makers take risks (risk takers) by holding securities inventory, subjected price
fluctuation, inventory risks etc.
o Brokers: trade on behalf of their clients, but do not trade for themselves (not risk-takers)
▪ Investors without access to the financial markets can send their orders to the brokers to
perform their trade
▪ Do not take positions themselves
o Broker-dealers: engaged in both activities listed above
▪ It may lead to conflict of interests, but to uphold their reputation it will withhold itself from
engaging in such activities
What do Market Makers do? IMC
• “IMC” Financial Markets is a global market maker that employs advanced technology and highly skilled traders
to buy and sell securities covering all major asset classes, and is also a Designated Market Maker on the NYSE.
Market Makers provide liquidity and thereby improve market efficiency.”
• A designated market-maker is an official market-maker with a contract relationship with stock exchanges,
committing to provide minimum levels of liquidity, quoting prices, and a minimum volume at these prices
Limit Order vs. Dealer Markets
• Limit order (or “Order-drive”) markets
o Traders submit orders to an exchange
(through their brokers)
o Orders are displayed in the limit order
book (LOB)
o NYSE/Euronext (and other stock
exchanges)
▪ “Designated” market makers
(DMMs) / Liquidity providers
ensure a minimum level of
liquidity
▪ Other dealers may provide
liquidity too; however, they
have no obligation to do so
• Dealer (or “Quote-drive”) markets
o Traders place orders with dealers
o Dealers trade with each other in an
interdealer market
o Dealer markets are very dispersed (e.g.
bond markets where banks trade with
itself)
o E.g., bonds, forex, etc.
,Market vs. Limit Orders
• Market Orders
o Instruction to trade at the best currently available price
▪ Not specifying the minimum or the maximum price you are willing to trade at
o Immediate execution vs. price uncertainty
▪ Traders are able to execute its trade immediately, but the trader face price uncertainty, where
the price of trade and price that you see in the limited order book is not the same
• Limit orders
o Instruction to trade at the best price available provided that it is no worse than the specified limit
price
o Limit orders that can be executed are known as marketable
o Advantage: possible price improvement
o Disadvantage
▪ Non-execution & cost of delay
▪ Adverse selection / Picking-off Risk: smarter & faster traders may trade against you precisely
when you would prefer not to be traded against
• Vulnerable where the prices may change very fast based on new information obtained
(e.g. market information, fundamental information etc.), which you are not aware of
Trading Mechanics in Limit Order Markets
• Opening price may be determined through a “call auction”
o Ex. Market opens at 9:30 (continues trading starts at 9:30)
▪ Before (around 9:00 – 9:30), investors may already have submitted their orders
▪ Orders are collected until the call auction takes place
▪ At 9:30, the price of the call auction is determined (at what price and at what quantity can the
submitted limit orders be executed)
▪ All marketable orders are executed at the determined price
▪ Non-marketable orders are placed in the limit order book
• At market opening, continuous trading begins
o Incoming market orders are executed at the best available prices
o Incoming non-marketable orders are added to the limit order book
o Resting limit orders are executed according to priority rules
▪ Price >>> Time >>> Visibility >>> Quantity
Call Auction
• Clearing price = max trading volume
o e.g. 4000 shares are traded at price 100
• Aim of call auction is to maximum trading volume
LOB at Market Opening
• Call auction has taken place and now LOB adjusted after the
marketable trades has been executed
• Best bid: 100; Best ask: 101
• Difference (Best ask – Best bid) → “Bid-ask spread” = 1
• Mid-point = 100,50 = (Best ask + Best bid)/2
• Relative spread = 1/100,50 = 0,995% = Bid-ask spread/Mid-
point
,9:31 Sell 500 Shares, Market
• Bid-ask spread not altered
• Market depth goes down (bid side became thinner) → less
volume on the bid side
• Market order consumes or drains liquidity
9:32 Buy 4500 Shares, Limit 100
• Spread again not altered, market depth increases on the bid
side
• Limit order provides or supplies liquidity
Latency (Delay)
• If limit order can be immediate executed, why not use market order?
• In today’s market, there will always be other traders who are faster than you (the bid or ask price you see may
not be available anymore when you put in your market order) → limit order book has changed already
o Thus, enter limit order to avoid price uncertainty, but faces non-immediacy execution
o Faster at accessing and processing information
o Faster at submitting and cancelling orders
Common Order Qualifiers
• Immediate or cancel (IOC): non-marketable part will be cancelled
• Fill or kill (FOC): execute the entire order or cancel
, Financial Markets – Lecture Notes Week 2
The 3 Dimensions of Market Liquidity
• The degree to which securities can be quickly bought or sold in possibly large quantities at prices that are close
to fundamentals
• Illiquid market increases the cost of capital, companies are more difficult to raise capital in IPO and so on,
affecting the economy as a whole
1. Market Tightness: how large is the bid-ask spread? (difference between best ask and best bid)
o Tight market = low spread
o Small trades carry transaction costs
o Bid-ask spread measures the transaction costs of small trades or the round-trip cost of a
small transaction
o The higher the bid-ask spread, the costlier it is for investors to buy and sell
2. Market Depth: what’s the price impact of (large) orders?
o Deep market: little price impact (the market can easily absorb large orders without such
orders having a huge price impact)
o Low sensitivity of price to changes in order flow (when the market is deep)
o Negative order flow is when there is more sell volume than buy volume
3. Market Resiliency: how quickly is liquidity replenished?
o How quickly do fresh limit order arrive? / How quickly do prices revert to their
fundamentals?
o Transaction price is very high when the market is not deep, leading to a very strong price
impact and liquidity will very quickly vanish
• When liquidity evaporates, larger orders have a substantial price impact (known as a thin market)
• A market is said to have a high resiliency when fresh liquidity is being provided quickly
The 2010 “Flash Crash”
Measuring Liquidity in Practice
1. Quoted Spread:
o Bid-ask spread: the difference between the best ask price and the best bid price
𝑆 = 𝑎−𝑏
o Relative bid-ask spread: normalized by the mid-quote
𝑎−𝑏
𝑆=
𝑚
𝑎+𝑏 𝑆 𝑠
Where: 𝑚 = 2 and half-spreads at 2 and 2
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