FINA3307 Lecture Notes PDF

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Semester 2, 2018. Notes from the whole semester....

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FINA3307: TRADING IN SECURITIES MARKETS Course Overview: [email protected] 

Main aim of course is to provide insights into complex workings of financial markets.

Assignments:  Tutorial participation – 10% (prepare one A4 page of preparation)  Trading sessions and reports (pre-game reflection report – 5% / post-game reflection report – 15%)  4 labs in 4, 5, 6, 8.  Pre-game reflection report (5%, due August 28th)  Post-game reflection report (15%, due October 9th)  Exams (mid-sem – 25% / final – 45%)  Mid-sem – week 7 (covers 1-6), MCQ only. 1 hour.  Final – exam period (covers week 1-12) 2 hours. Lecture 1: The Trading Process Why do markets exist?  Basic function of market is to bring together buyers and sellers.  Capital allocation:  Capital market necessary for economic growth and development.  Companies need capital to fund projects.  Secondary market.  Price discovery and liquidity  Price discovery is process of determining price for an asset through interaction of buyers and sellers.  Investing is linked to rationale to buy or sell (e.g. exploit undervaluation)  Trade decision concerns how to execute investment decision, in which markets, and at what prices etc. (acquisition of information, routing of the order, execution of trade, confirmation, clearance and settlement) Overview of trading process Who are participants?  Two sides of trading industry:  Buy side (people / institutions who use financial services) – incl. individuals, corporate, pension / investment funds, insurance reserve funds, Gov. funds.  Sell side (those who provide these services) – incl. brokers, exchanges, clearing houses, depositories and custodians, dealers.

Why do they trade?  Utilitarian traders  Investors, borrowers, asset exchangers, hedgers, tax-avoiders.  Profit-motivated traders  Speculators, arbitrageurs, dealers, algorithmic traders. What instruments are traded?  Real assets produce cash flows over time (e.g. plant, machinery, factories etc.)  Financial assets are instruments that represent ownership of real assets and cash flow they produce (e.g. bonds)  Derivative contracts derive their values from other instruments values.

What are orders?  Orders – instructions to trade, given to brokers / exchanges.  Always specify – item to be traded, quantity, side *buy or sell)  May specify – price (subject to tick rule), method (e.g. whether can be partially filled), timing (when order can be executed), expiration, market, counterparts (trade with whom) Limit Orders  Limit order instructs the broker to trade at best price available, but do not violate limit price condition (do not buy at price above limit price / do not sell at price less than limit price)  Properties of limit orders – limit orders may not execute.  Standing limit orders supply liquidity by allowing others to trade when they want. Market Orders  Market orders are buy or sell orders that are to be executed immediately at ‘market’ price.  E.g. there is a trader who has flagged that he’s willing to sell commodity A for $100, and another who wants to buy at $95. You want to buy at market price – if you’re willing to pay $100 to acquire commodity, you have placed / used a market order.  Prosperities of market order – consumption of liquidity (take away shares from market), have market impact when brokers move prices to find liquidity, and execution is near certain (not always) but execution price maybe uncertain. Stop Orders  Stop orders are price contingent orders.  Activate when their price contingency is met.  Almost always market orders.  Typically are use to close losing positions.  E.g. market sell order of BHP sales with stop price of $9.00. If price falls to $9.00 or below, broker will sell the shares at best price then available to market. Orders that stipulate duration  Day order.  Good still cancelled order.  Fill or kill orders.  Immediate or cancel orders. Trading process  How do we arrive at ‘price’ – depend on trading mechanism  Bargaining  Auctions (in order of real-world frequency)  Oral, ascending price auction.  First price, sealed-bid auction  Oral, descending price auction  Second price, sealed-bid auction.  Double auctions / bilateral auctions.  Auction – competitive market process involving multiple buyers, multiple sellers or both (they are useful and cost effective method for pricing a security with an unknown value)  Walrasian auction – simultaneous auction where each buyer submits to auctioneer his demand and each seller submits his supply for given security at every price possible (e.g. opening and closing auctions on ASX)  English auction – involves public sequences of bids, and provides for some degree of price discovery before it concludes. Ends with a ‘winner’ declared when no participant willing to bid higher.  First price sealed-bid auction – all bidders simultaneously submit sealed bids. Winner is one that submits highest bid and pays bid price (doesn’t allow for price discovery)

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Dutch auction – descending bid auction. Continuous double auction – buyers submit bids (max. buy prices) and sellers submit offers (min sell prices). Bids and offers ranked by their price levels, and transaction occurs when highest bid and lowest offer match (e.g. stock markets such as NYSE and ASX) Periodic auctions – high frequency auction.

Lecture 2: Market Structure What are different execution systems?  Trading rules and trading systems used by market is defined as market structure.  Determines what traders can do and know in a market.  Affects information asymmetry in market and affects that trades profitably.  Affect trading strategies.  Sessions – call (price determined when market is called), continuous.  Execution systems:  Quote-driven  Public traders cannot arrange trades amount themselves – dealers supply liquidity, and dealers quote their bid and ask prices.  Information asymmetry problem.  Order-driven  All traders issue orders to exchange  Trading within intermediation of dealer.  Brokered markets  Brokers actively arrange trades in brokered markets.  Trade initiators contact the broker, and broker then tries to find counterparties.  Brokered markets – item traded is somehow unique and when dealers are unwilling to hold inventories.  Hybrid  Mix elements of various market types.  Most common hybrid markets are those with dealer-specialists – these markets are orderdriven auction markets in which the specialist must provide liquidity under some circumstances.  Most are hybrid these days.  Information systems (bring information into and out of the market) – information collection / distribution systems, order routing / presentation systems.  Order presentation systems (manage exchange of information about orders and present orders for consideration) – open outcry auctions (oral), board-based trading systems, screen based trading systems. Order Books  Order books manage and store information about standing orders (electronic or paper based)  Order books hold extremely valuable information (front-running opportunities, arbitrages)  Traders need to leave standing limit orders in order books for order-book matching system to work – some traders do not want to show their orders (granting option to other traders) Price steps  Price steps are minimum price multiples for a security (depends upon market price of security)  EXAMPLE: Market Price Minimum Price Step Examples 0.1c – 9.9c 0.1c EFG is priced at 3c. Valid price orders include: 2.9c, 3.9c, 3.1c 10c – 199.5c 0.5c EFG is priced at 26c. Valid order prices include: 22.5c, 24.5c, 25.0c 200c – 99900c 1c KLM is priced at $5. Valid order prices include: $5.05, $4.02. Transparency  Transparent markets report complete information to public quickly.

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Ex ante transparent:  Market that quickly reports all quotes and orders to public.  Before trade happens / has occurred.  Ex post transparent:  Market that quickly reports all trades to public. Investors like both ex ante and ex post transparency.

How are prices and trades determined?  Order precedence  Precedence rules – how tick size matters, how ex-ante transparency matters  Trade pricing  Discriminatory pricing rule  Uniform pricing rule Order Precedence Rules  ORP facilitate matching of buy orders with sell orders.  Trades are arranged by matching highest ranking buy orders with highest ranking sell orders subject to – buyer willing to pay as much or more than seller is willing to receive.  ORP vary across markets:  Price priority is almost always first rule.  Who has priority?  Buy limit orders with higher prices  Sell limit orders with lower prices.  Other / secondary precedence rules:  Time precedence rules  Under time precedence, all orders at price are ranked by arrival times.  In many floor systems – only first order (or quote) at price has time precedence.  All other orders at that price are at parity with each other.  All things equal, it is the earlier one that takes precedence.  Tick size affects time precedence rule (if tick size wide, time precedence rule is more important)  Price priority rule  Rule is self-enforcing.  Seller always seeks the buyer bidding the highest price.  Buyer always seeks seller offering lowest price.  At given price, traders usually do not care about with whom they trade.  Gives best economic outcome from trading.  PP matching rule ensures total gains from trade is maximised.  Displayed order precedence (visibility)  Size precedence rules.  Public order precedence. Trade Pricing Rules  Pricing rules determine trade prices.  Pricing rules vary across exchanges and also across sessions on same exchange:  Call / periodic markets use uniform pricing rule.  Collect orders for batch processing.  Most continuous order-driven trading systems use discriminatory pricing rule.  Arrange trades continuously as orders arrive.  Uniform pricing rule:  Used (1) at market open in many equities exchanges and (2) following trading halts.  All matched orders are executed at same price.  Exchange matches orders by price priority to maximise total volume of trade.

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At 10.12 – 8 shares will be traded. At 10.13 – 4 shares will be traded. 10.12 is clearing price in order to maximise trade. Minimise excess demand. GRAPH – x-axis is quantity, y-axis price. 

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8 shares will be traded at 10.12 and 10.13. ASX resolves opening price using set of rules:  Principle 1 – maximum executable volume  Principle 2 – establishing minimum surplus.  Principle 3 – ascertaining where market pressure exists.  Principle 4 – consulting reference price.

Other Pricing rules  Discriminatory pricing rule  In continuous trading, trade takes place when incoming order is matched with standing limit order.  Trade price is limit price of standing order  For each unit, could be different price.  Derivative pricing rule  In crossing networks, matching orders executed at prices determined elsewhere.  Problems plague derivative markets. Alternative Trading Systems (ATS)  Trading venue that is not registered with SEC as an exchange – it centralizes, crosses, matches and executes trading interest.  Provide electronic forums for linking dealers with each other and with institutional investors.  Difference – ATS offer trading services only, whereas exchange offers clearing and settlement as well etc.  Types of ATS:  Electronic Communication Networks (ECNs) – e.g. Instinet, Archipelago.  Dark Pools and “Crossing Networks”  Internalization Crossing Networks  Voice-Brokered Third Party Matching. Lecture 3: Institutional Trading and Liquidity Uniform Price Auction    

According to 4 principles: Vol. traded – have 2 values that are same so move onto minimum surplus. Ex. Demand – take absolute value, and find min. value is 7. Hence, opening price is 5.12.

How was trading conducted on NYSE?  Largest stock exchange in world (formed 17 May 1792)  Prior to 2006, most trades conducted on floor by ‘trading crowd’.  One specialist for each stock:  Affirmative obligations to offer liquidity – traders of last resort.  Negative obligations – yield to public orders.  Maintained book containing all unexecuted securities  Significant trading advantages relative to other market participants.  2006 – demutualized and merged with Archipelago

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Role of specialist has been passed onto designated market makers (DMMs) DMMs no longer possess trading advantages, as they have no special access to order books. SuperDOT trading system replaced by NYSE Super Display Book System for routing and processing orders.  Customers able to execute orders in quickly as 5 milliseconds.  No longer needed ot present orders at trading post by commission broker. Floor trading diminished significantly since merger. DMMs involved in less than 1 in 30 transactions. DMM face relatively light obligations (must quote at NBBO at least 15% of time, and maintain quote no more than 8% away from NBB / NBO) – required to offer liquidity in order book.

National Best Bid and Offer (NBBO)  Consolidated quote system (CQS) consolidates and broadcasts each market centre’s best bid and offer.  Highest bid at any given time known as National Best Bid (NBB)  Lowest ask price at any given time known as National Best Offer (NBO)  NBBO is regulation by SEC that requires brokers to execute customer trades at best prices available for buying and selling securities.  Example:  What is NBBO at 9:35?  Best bid is 70.05.  Best offer is 70.15 (only consider latest time, A updated their offer) How is trading conducted on ASX?  Centralized Limit Order Book  No DMMs, no specialists. What is Liquidity?  Liquidity refers to asset’s ability to be easily purchased or sold without causing significant change in price of asset.  Assets can be easily traded with low transactions costs at any time with little impact on asset’s price.  More market participants, the better.  Always bid and asked prices for investor who wants to buy or sell small amount of stock immediately (spread is small)  Investor who buy or sell large amount of stock, in absence of special information, can do so over long period of time at price not very different from current price.  Investor can buy or sell large block of stock immediately but at premium or discount that depends on size of block. Definition of Liquidity  A market is liquid if uninformed traders can quickly buy or sell large size when they want at a low transaction cost.  Width – cost per unit.  Depth – size available at given cost.  Resiliency – time that passes before traders recognize uninformed traders have caused prices to change. Institutional Traders  Institutional investors incl. mutual funds, pension funds, life insurance companies, trust departments of banks and investment companies.  Buy side institutions accept money from investors for purpose of investing on their behalf.  Institutional transactions are executed by professional traders in institutions or acting as their agents.  Execution of these orders likely impact price.  Registered investment companies  Investment companies manage assets on behalf of clients:  Assets incl. publicly traded financial securities, bonds, shares, derivatives etc.

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Types of investment company:  Closed end Investment Company – corporation that issues a specified number of shares that can be traded on the exchange.  Open end Investment Company – accept additional funds and repurchase shares directly from investments.  Exchange Traded Funds – shares traded on exchange but differ form closed end investment companies. Unregistered investment companies  Pension funds – established by US employers to facilitate and organise investment of employee’s retirement funds.  Private equity – asset mangers who make equity investment in companies that are not publicly traded.  Hedge funds – unregistered private funds that allow investors to pool their investment assets.  Invest in assets where other institutions are prohibited (e.g. securities of distressed companies.. conduct short sales and derivative to profit from market downturns and arbitrages)

How do institutions trade?  Estimated in 1994, institutional trading accounted for 75-80% of NYSE.  Common for institutions to break their order into smaller tranches spread over extender period of time.  Slice and dice (risk being front run) – putting small orders into market, signalling risk from orders.  Missed opportunity cost – period extended, price you see now could change significantly and would miss opportunities.  Complex orders:  Iceberg orders – only small part of order is shown in limit order book, while larger part is hidden (as executions are realized, successive part of order are entered in limit order book)  E.g. iceberg order to buy 25,000 @ 100p with peak = 10,000.  Trading strategies  Minimise trading costs by revealing minimal information about their trading intentions to market  Algorithmic trading  Refers to automated trading with use of live market data and rule-driven computer programs.  For automatically submitting and allocating trade orders among markets and brokers.  As well as over time so as to minimise price impact of large trades.  Many institutional trader use this trading to reduce execution risk, preserve anonymity and minimise trade slippage  Trade slippage = market impact of trade (i.e. Pt+k – Pt)  Relation between trade slippage and transaction size likely to be nonlinear. Dark Pools  Dark pools do not post quotes or transaction prices (function in parallel with traditional markets)  Types of dark pools:  Public crossing networks (cross buy and sell orders at spread mid-point) – derivative pricing rule.  Internalisation pools – broker provides both buy and sell flow from its own proprietary desks and its customers.  More attractive for uninformed traders. Dark Executions  Typically arise from one of following mechanisms:  Hidden (undisplayed) limit order in limit order market (like NASDAQ) that also handles visible orders.  Executions in bisible markets.  NASDAQ market order (MM) trades against customer order at NBBO at time when MM’s own quotes are behind NBBO (internalisation)  Trade occurs in crossing network or dark pool that posts no quotes of itws own, but matches buyers and sellers at pries determined by NBBO (trades in dark pools)

Stealth and sunshine trading  Stealth trading – where privately informed traders fragment their large order, routing them to different markets and at different time to disguise their intentions.  Large trades will reveal information.  Small trades will incur excessive transaction costs.  Medium trades will be used by informed traders.  Institutions use larger and smaller transactions. Why?  Institutions prefer small and medium transactions when trading on high volume days. Large transactions on high volatility days.  Sunshine trading – traders announce their intentions  Attempt to attract more liquidity providers to market.  If trades are not information driven – may get better prices than stealth trading.  E.g. 2011 when US Gov. announced plan to sell bank shares accumulated during 2008 crisis. Institutional Trading Needs?  Volatility  Share prices fluctuate with market uncertainty and also illiquidity in market.  Transparency  “Everyone wants to see liquidity, but no one is actually going to put his or her order there. Everyone wants market to be transparent, but nobody wants anyone else to see what they themselves want to do.”  Day trader, hedge funds and other pilfered research done by institutional investors.  Consolidation of order flow  Consolidation refers to pooling of order flow in one market center (increases order interaction, concentrates liquidity and improves accuracy of price discovery)  Fragmentation both ‘spatial’ and ‘temporal’ due to ‘slice and dice’  Affects quantity discovery and price discovery.  Increases intraday price volatility. Price impact of institution trading  Price changes decomposed into two componen...