Class notes
ECON0001 Week 1
- Course
- Institution
In depth notes on ECON0001 Week 1
[Show more]
Seller
Follow
zctpfru
Content preview
Week 1Institutional details and measures of liquidity
FPR Ch.0-2
Price formation
• Traditional approach to financial economics, the price formation process is a ‘black box’
• In the standard economics paradigm it is the intersection of supply and demand curves for a
particular good
• Two traditional approaches to price formation
◦ It is irrelevant: what matters is the equilibrium, so only need to solve for market clearing
‣ Implicit in this approach is that the trading mechanism plays no role in determining the
equilibrium, so that whichever mechanism is employed the equilibrium is the same
◦ Fiction of the walrasian auctioneer
‣ Traders submit demand schedules to the auctioneer
‣ There is no trading allowed outside equilibrium and incentive issues are not considered
Frictions
Frictionless vs friction
• Frictionless securities markets
◦ All market participants are in the same market at the same time, and are price takers
◦ An auctioneer finds the market clearing price that reflects the “consensus” view on the
security’s fundamentals
◦ Order-flow has no impact on prices
◦ Information is assumed to be homogeneous
◦ There are no “frictions” (commissions, cost to acquire information)
• Frictions in real world markets
◦ Not all market participants may be in the market at the same time or in the same physical/
virtual location
◦ Not everybody shares the same information Expected priceprior oftraderi y
◦ The order flow impacts transaction prices Bia all
infocity
Exogenous
◦ Information is endogenous Endogenousinfoxilyi.ptlyi.tl
◦ Prices deviate from perfect market “consensus”
‣ Extent of deviation: “Illiquidity” i e measureofe aseogfettingwhatyou want
‣ Speed of convergence to consensus: “Price discovery”
Importance of frictions
• Illiquid markets high trading costs, which lower securities’ returns leading investors to demand
, offsetting discount higher cost of capital
• Slow discovery errors in investment decisions (individuals and companies)
Market microstructures
• Study of price formation that explicitly accounts for the existence of frictions
• Market microstructure analyses how specific trading protocols affect the price formation process
• Useful for the regulation of markets and the design and formulation of new trading mechanisms
Models
Inventory-based models
• Primary role assigned to market-makers as liquidity providers
• Bid-ask spread compensate them for price risk on inventory
2 Information-based models
• Traders have asymmetric information on the assets’ true value
• The bid-ask spread compensates for adverse selection costs
The players
• Any trading mechanism can be viewed as a type of trading game in which players meet (perhaps
not physically) at some venue and act according to some rules
• The players may involve a wide range of market participants, although not all types of players are
found in every market mechanism
◦ Traders/investors: the end-“consumers” or suppliers of the asset
‣ Retail investors vs institutional investors
‣ Informed vs uninformed investors
◦ Brokers: the intermediaries who relay investors’ orders to the market (investment banks)
◦ Dealers/market-makers: match orders from different sides of the market
Trading venues
• Exchange trading
◦ Regulated
◦ Liquidity and stability through market makers
◦ Clearing and settlement, ie. ownership of money and assets is verified
◦ Transparency
• Over-the-counter (OTC) trading
◦ Off-exchange venues
‣ Use quotation systems to match dealers and traders
‣ No guarantee of liquidity
Sellascendingprice
‣ No transparency: may not publish trade information
Buydescending
Trading mechanisms
• Order driven
◦ Call/ batch limit order markets:
‣ Orders are collected (in a batch) and cleared at a
certain frequency (eg. Once a day)
‣ The price is chosen so that the market clears
‣ Uniform price: all executable orders are filled at the
same price
The benefits of buying summaries with Stuvia:
Guaranteed quality through customer reviews
Stuvia customers have reviewed more than 700,000 summaries. This how you know that you are buying the best documents.
Quick and easy check-out
You can quickly pay through credit card or Stuvia-credit for the summaries. There is no membership needed.
Focus on what matters
Your fellow students write the study notes themselves, which is why the documents are always reliable and up-to-date. This ensures you quickly get to the core!
Frequently asked questions
What do I get when I buy this document?
You get a PDF, available immediately after your purchase. The purchased document is accessible anytime, anywhere and indefinitely through your profile.
Satisfaction guarantee: how does it work?
Our satisfaction guarantee ensures that you always find a study document that suits you well. You fill out a form, and our customer service team takes care of the rest.
Who am I buying these notes from?
Stuvia is a marketplace, so you are not buying this document from us, but from seller zctpfru. Stuvia facilitates payment to the seller.
Will I be stuck with a subscription?
No, you only buy these notes for $9.29. You're not tied to anything after your purchase.
Can Stuvia be trusted?
4.6 stars on Google & Trustpilot (+1000 reviews)
66579 documents were sold in the last 30 days
Founded in 2010, the go-to place to buy study notes for 14 years now