Financial Markets, Institutions, and the Trading EnvironmentSlide 1 Financial Markets, Institutions,...

Slide 1Financial 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

Slide 2Financial Markets, Institutions, and the Trading Environment

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

Slide 3Financial Markets, Institutions, and the Trading Environment

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

Slide 4Financial Markets, Institutions, and the Trading Environment

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

Slide 5Financial Markets, Institutions, and the Trading Environment

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.)

Slide 6Financial Markets, Institutions, and the Trading Environment

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)

Slide 7Financial Markets, Institutions, and the Trading Environment

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?

Slide 8Financial Markets, Institutions, and the Trading Environment

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

Slide 9Financial Markets, Institutions, and the Trading Environment

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

Slide 10Financial Markets, Institutions, and the Trading Environment

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

Slide 11Financial Markets, Institutions, and the Trading Environment

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

Slide 12Financial Markets, Institutions, and the Trading Environment

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*

Slide 13Financial Markets, Institutions, and the Trading Environment

The Big Problem

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

Two Dimensions Place Time

Slide 14Financial Markets, Institutions, and the Trading Environment

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

Slide 15Financial Markets, Institutions, and the Trading Environment

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

Slide 16Financial Markets, Institutions, and the Trading Environment

10:50 10:55 11:00

PublicBuyer

PublicSeller

DealerBuys

DealerSells

Dealer Intermediation

Dealer provisionof immediacybrings buyer

& seller together

Slide 17Financial Markets, Institutions, and the Trading Environment

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

Slide 18Financial Markets, Institutions, and the Trading Environment

Order Driven Market

Best Ask 100 shs @ $20.00

Best Bid 200 shs @ $10.00

<Last sale $15

Slide 19Financial Markets, Institutions, and the Trading Environment

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

Slide 20Financial Markets, Institutions, and the Trading Environment

Dealer/Specialist “Makes” the Market

Best Public Ask 100 shs @ $20.00

Best Public Bid 200 shs @ $10.00

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

Specialist Bid 100 shs @ $14.95

Slide 21Financial Markets, Institutions, and the Trading Environment

Public Trades with Dealer

Best Public Ask 100 shs @ $20.00

Best Public Bid 200 shs @ $10.00

< Mkt order: Sell 100

< Sold @ $14.95

<

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

Specialist Bid 100 shs @ $14.95

Slide 22Financial Markets, Institutions, and the Trading Environment

Dealer Is Long 100 Shares

Best Public Ask 100 shs @ $20.00

Best Public Bid 200 shs @ $10.00

Specialist Ask 100 shs @ $15.05

Specialist Bid 100 shs @ $14.95 $14.90

Slide 23Financial Markets, Institutions, and the Trading Environment

10:50 10:55 11:00

PublicBuyer

PublicSeller

A Call Auction

A meeting pointin time can bring multiple buyers &

sellers together

Slide 24Financial Markets, Institutions, and the Trading Environment

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

Slide 25Financial Markets, Institutions, and the Trading Environment

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

Slide 26Financial Markets, Institutions, and the Trading Environment

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

Slide 27Financial Markets, Institutions, and the Trading Environment

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

Slide 28Financial Markets, Institutions, and the Trading Environment

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* =

Slide 29Financial Markets, Institutions, and the Trading Environment

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!

Slide 30Financial Markets, Institutions, and the Trading Environment

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.

Slide 31Financial Markets, Institutions, and the Trading Environment

Three Other Market Characteristics

Immediacy

Liquidity

Volatility

Slide 32Financial Markets, Institutions, and the Trading Environment

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

Slide 33Financial Markets, Institutions, and the Trading Environment

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

Slide 34Financial 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

Slide 35Financial Markets, Institutions, and the Trading Environment

Market Structures

Slide 36Financial Markets, Institutions, and the Trading Environment

Topic 6

Liquidity

Slide 37Financial Markets, Institutions, and the Trading Environment

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

Slide 38Financial Markets, Institutions, and the Trading Environment

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

Slide 39Financial Markets, Institutions, and the Trading Environment

What Do the Following Have in Common?

Without Gas, Neither Will Run

Slide 40Financial Markets, Institutions, and the Trading Environment

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”

Slide 41Financial Markets, Institutions, and the Trading Environment

Illiquidity

High Intra-Day Volatility

High First ½ Hour volatility

A Problem For All MarketsA Bigger Problem for Small Cap Stocks

Evidence of Illiquidity

Slide 42Financial Markets, Institutions, and the Trading Environment

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.

Slide 43Financial Markets, Institutions, and the Trading Environment

Liquidity

Little breadth, depth, or resiliency

Accentuated short-period price volatility

Attributes of an illiquid asset

Slide 44Financial Markets, Institutions, and the Trading Environment

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

Slide 45Financial Markets, Institutions, and the Trading Environment

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

Slide 46Financial Markets, Institutions, and the Trading Environment

Building Liquidity

1. Attract Investor Attention

Stocks are not bought

They are sold

Slide 47Financial Markets, Institutions, and the Trading Environment

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

Slide 48Financial Markets, Institutions, and the Trading Environment

Building Liquidity

3. Attract Limit Orders

Commission Structure Rules of Order Execution

Strict Time and Price Priorities Tick Size

Slide 49Financial Markets, Institutions, and the Trading Environment

Building Liquidity

4. Role of Intermediaries

Natural vs Supplemental Liquidity Dealer Capital Animate the Market

Slide 50Financial Markets, Institutions, and the Trading Environment

Building Liquidity

5. Involve the Listed Companies

Natural vs Supplemental Liquidity

Slide 51Financial Markets, Institutions, and the Trading Environment

Building Liquidity

6. Include Call Auction Trading

Slide 52Financial Markets, Institutions, and the Trading Environment

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

Slide 53Financial Markets, Institutions, and the Trading Environment

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

Slide 54Financial Markets, Institutions, and the Trading Environment

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

Slide 55Financial Markets, Institutions, and the Trading Environment

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

Slide 56Financial Markets, Institutions, and the Trading Environment

Making the Trade

(based on Navarro chapters)

Slide 57Financial Markets, Institutions, and the Trading Environment

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

Slide 58Financial Markets, Institutions, and the Trading Environment

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

Slide 59Financial Markets, Institutions, and the Trading Environment

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.”

Slide 60Financial Markets, Institutions, and the Trading Environment

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”

Slide 61Financial Markets, Institutions, and the Trading Environment

Topic 8

Institutional Order Flow

Slide 62Financial Markets, Institutions, and the Trading Environment

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

Slide 63Financial Markets, Institutions, and the Trading Environment

Price and Quantity Discovery

Institutions avoid active participation in price discovery

Institutional and retail order flow should be integrated

Latent demand (invisible quantity)

Slide 64Financial Markets, Institutions, and the Trading Environment

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

*

Slide 65Financial Markets, Institutions, and the Trading Environment

• 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.)

Slide 66Financial Markets, Institutions, and the Trading Environment

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

Slide 67Financial Markets, Institutions, and the Trading Environment

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

Slide 68Financial Markets, Institutions, and the Trading Environment

Best Execution

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

Speed Certainty Anonymity Control Etc.

An order is multi-dimensional.

Slide 69Financial Markets, Institutions, and the Trading Environment

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.

Slide 70Financial Markets, Institutions, and the Trading Environment

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

Slide 71Financial Markets, Institutions, and the Trading Environment

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

Slide 72Financial Markets, Institutions, and the Trading Environment

Impediments to Best Execution

• Soft dollar commitments

• Use of an erroneous benchmark

• Excessive pressure to trade quickly

• Imperfect market structure

Slide 73Financial Markets, Institutions, and the Trading Environment

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

Slide 74Financial Markets, Institutions, and the Trading Environment

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?)

Slide 75Financial Markets, Institutions, and the Trading Environment

Consequences

Higher trading costs

Lower investment performance

immediacy Induced demand for