Financial market regulations

Self-regulation

Government Regulation

SGX NYSE NASDAQ

Reasons for trading

Protocol for trading

Many Prices

Liquidity?

Action

Condition Price below the limit Price above the limit Buy Limit-Buy Order Stop-Buy Order Sell Stop-Loss Order Limit-Sell Order

(qB,pB) Buy = (qB,) Sell = (qS, 0)

(qS,pSS)

Suppose the market has received the following orders at the time it is due to generate an open price.

Price

Quantity

Each incoming order is equally likely to be buy order as a sell order. The buy order is executed at the ask price, pA whereas the sell order is executed at the bid price, pB. Thus, the fundamental price is somewhere between bid price and ask price. The bid-ask spread is S = pA - pB.

Probabilty 1 2 3 4 5 6 7 8

t-1(1) pA pA pA pA pB pB pB pB

t(2) pA pA pB pB pB pB pA pA

t+1(3) pA pB pA pB pB pA pA pB

(1)-(2)/(2) in t [pA - pA]/ pA = 0 [pA - pA]/ pA = 0 [pB - pA]/ pA = - S/pA [pB - pA]/ pA = - S/pA [pB - pB]/ pB = 0 [pB - pB]/ pB = 0 [pA - pB]/ pB = S/pB [pA - pB]/ pB = S/pB

(3)-(2)/(2) in t+1 [pA - pA]/ pA = 0 [pB - pA]/ pA = - S/pA [pA pB]/ pB = S/pB [pB pB]/ pB = 0 [pB - pB]/ pB = 0 [pA - pB]/ pB = S/pB [pA - pA]/ pA = 0 [pB pA]/ pA = -S/pA

In the above table, t-1 represents previous transaction; t represents current transaction; t+1 represents next transaction. The first four columns illustrate each probability what the price will be at t-1, t, and t+1. The fifth column represents the past return between previous price and current price. The sixth column represents the future return on current price and the price of next transaction. There are eight different probabilities. If the current transaction is at ask price, the past return is either 0 or S/pB and the future return is either 0 or -S/pA. If the current transaction is at bid price, the past return is either 0 or -S/pA and the future return is either 0 or S/pB.

Transition: Probabilities - S/pA 0 S/pB

- S/pA 0 0.125 0.125

0 0.125 0.125+0.125=0.25 0.125

S/pB 0.125 0.125 0

Assuming that all outcome are equally likely (e.g. 1/8 = 0.125), the above table of transition of probabilities is obtained. The last three entries in the first row represent the future return. The last three entries in the left column represent the past return.

Therefore, the autocovariance can be expressed as: Autocovariance = E(Future Return)(Past Return) E(Future Return) x E(Past Return) where E represents expected Autocovariance = P[E(Future Return)(Past Return)] - E(Future Return) x E(Past Return) where P represents probability Autocovariance = [(0)(- S/pA)( - S/pA)] + [(0.125)(0)( - S/pA)] + [(0.125)(S/pB)( - S/pA)] + [(S/pA)(0)(0.125)] + [(0.25)(0)(0)] + [(0.125)(S/pB)(0)] + [(0.125)( - S/pA)(S/pB)] + [(0.125)(0)(S/pB)] + [(0)(S/pB)(S/pB)] Autocovariance = [(0.125)(S/pB)( - S/pA)] + [(0.125)( - S/pA)(S/pB)] Autocovariance = (0.25)(S/pB)( - S/pA) Autocovariance = (0.25)(-S2/pApB) or -S2/4pApB (1) From equation (1), the price process of stock contains, therefore, negative autocovariance that is increasing in the bid-ask spread of the stock. Negative autocovariance implies that high returns tend to be followed by low returns and vice versa.

Adverse selection is the result of informed people self-select in a way that is harmful to the uninformed people in the market. Consider the adverse selection illustration on how informed traders have the scope to selfselect. Suppose uninformed trader, say trader A, want to trade a stock with payoff x. Trader A thinks there is equal chance the payoff x is 1 or 0. In this case, trader A is willing to trade at a price between 0 and 1. On the other hand, informed trader, say trader B, knows for sure whether x equals 1 or 0. If the true payoff is 1, trader B only trade if he is buying and turn down all sell transactions at any price that is strictly lower than 1. In this buy transactions, trader B makes a trading gain and trader A makes a trading loss of 1-p per unit. Similarly, if the true payoff is 0, trader B only trade if he is selling and turn down all buy transactions at any price that is strictly greater than 0. In this sell transactions, trader B makes a trading gain and trader A makes a trading loss of p-0 per unit. As a result, no matter what transaction price p is, the trader A always makes trading loss if he trades. In this case, trader A is better off by not making any trade

Glosten-Milgrom model attempts to take adverse selection into account when the market maker sets the bid-ask spread. The major assumption of this model is a sequential arrival sequence, where each trader is either liquidity trader uninformed- or insider trader. The amount traded is fixed. Liquidity traders are equally likely to buy or sell whereas insider traders will buy or sell depending on their information set. If the information set is optimistic, insider traders bunch together on the buy side. Likewise, if the information set is pessimistic, insider traders bunch together on the sell side. This poses dilemma for market maker, who is to clear incoming order imbalance. On one side, he provides liquid to liquidity traders and on other side, he is vulnerable to the activity of insider traders. In this case, market maker knows that liquidity traders are spread equally on both sides of the market whereas insiders tend to go to one side only. Therefore, market maker will become worried if consecutive buy or sell orders arrive. This will prompt him to change his quotes accordingly.

1-p

Liquidity Trader

buy 1/2 1/2 sell buy 1

1/2 x (1-p) x 1/2 = (1-p)/4

1/2 x (1-p) x 1/2 = (1-p)/4 1 x p x 1/2 = p/2

1 high 1/2 p Insider

sell

0 x p x 1/2 = 0 1/2 x (1-p) x 1/2 = (1-p)/4

low

1/2 0

1-p

buy Liquidity 1/2 Trader 1/2 sell buy 0 Insider 1 sell

1/2 x (1-p) x 1/2 = (1-p)/4 0 x p x 1/2 = 0

1 x p x 1/2 = p/2

The above diagram illustrates the scenario. Suppose the market maker thinks there is a probability p that the next trader is an insider and 1-p that the next trader is liquidity trader. If the next trader is a liquidity trader, he is equally likely to buy or sell. If the next trader is insider, he buys for sure if the asset value is high and sell for sure if the asset value is low. Suppose the high value of asset is 1 with probability and low value of asset is 0 with probability. In this case, market maker revises his belief contingent on selling at ask and buying at bid. If the buy order arrives, the market maker sells at ask price. If the sell order arrives, the marker maker buys at bid price. In the case of buy order, the probability the market maker trade with liquidity trader is (1-p)/2

By the Bayes rule, the probability that the asset value is high contingent on selling at the ask is:
Pr(High|Sell at ask) = = Pr(Sell at ask| High)Pr(High) Pr(Sell at ask | High)Pr(High) + Pr(Sell at ask | Low)Pr(Low) [(1-p)/4] + p/2 [((1-p)/4) + (p/2)] + ((1-p)/4) [(1-p)/4] + p/2 [((1-p)/4) + (2p/4)] + ((1-p)/4) [(1-p)/4] + 2p/4 [((1-p)/4) + (2p/4)] + ((1-p)/4) (1/4) (p/4) + 2p/4 (1/4) (p/4) + (2p/4) + (1/4) - (p/4) (1/4) + 2p/4 (p/4) (1/4) + (1/4) + (2p/4) - (p/4) (p/4) (1/4) + p/4 (2/4) (1/4) + p/4 (1/2) 2[(1+ p/4] (1+ p)/2

= = = = = = =

Therefore, the market maker thinks the expected value of the asset, contingent on selling at the ask, equals Expected(Value | Sell at ask) = ([(1+p) / 2][1]) + (1-[(1+p) / 2][0]) = (1+ p) / 2 If the market maker acts competitively and is risk neutral (zero inventory risk), he quotes an ask price that is greater than unconditional expected asset value of .

By the Bayes rule, the probability that the asset value is high contingent on buying at the bid is: Pr(High | Buy at bid)Pr(High) Pr(High | buy at bid) = Pr(High | Buy at bid)Pr(High) + Pr(Low | Buy at bid)Pr(low) (1-p)/4) = [((1-p)/4)] + [((1-p)/4) + (p/2)] (1-p)/4) = [((2-2p)/4) + (p/2)] (1-p)/4) = [((2-2p)/4) + (2p/4)]
= (1-p)/4) [(2/4) (2p/4)] + (2p/4) ((1-p)/4) (2/4) ((1-p)/4) (1/2) 2(1-p)/4) (1-p)/2

= = = =

Expected(Value | buy at bid) = ([(1-p) / 2][1]) + (1-[(1-p) / 2][0]) = (1- p) / 2

Therefore the optimal ask price is (1+p)/2 and the optimal bid price is (1-p)/2. Bayes rule assumes that market maker has a prior probability distribution of events. Market maker observes traders attempt to trade at bid or the ask side. Market maker revises his beliefs about the probability distribution over asset values. Thus, the bid and ask prices are determined according to the posterior probabilities rather than the prior probabilities. In this case, market maker does not regret about the bid and ask prices he sets. The rational price setting in the framework of Glosten-Milgrom is in the line with efficient market hypothesis framework. Efficient market hypothesis framework is based on the random walk hypothesis. Random walk hypothesis implies that if the market thinks the price should go up in the future, it adjust the price immediately to reflect this information. Therefore, the future price becomes equally likely to go up as to go down from the current level.

The likelihood that noise traders are active in the market is 90%, and if they trade they buy with probability 60% and sell with probability 40%. There are also informed traders active (with the complementary probability 10%) who have perfect knowledge of the asset payoff, and these traders can trade in the direction that yields the greatest trading profits. To the rest of the market, the asset is worth 110 with probability 50% and 90 with probability 50%. Work out the bid and ask price in the first round of trading, using the Glosten-Milgrom model.
buy 0.90 Liquidity Trader 0.60 0.40 sell 110 high 0.50 0.10 Insider 1 0 sell buy 0.60 0.40 0.10 0 1 sell sell buy buy

Pr(Buy|110) = (0.90 x 0.60) + (0.10 x 1) = 0.54 + 0.10 = 0.64 Pr(Sell|90) = (0.90 x 0.40) + (0.10 x 1) = 0.36 + 0.10 = 0.46 Pr(Sell|110) = (0.90 x 0.40) + (0.10 x 0) = 0.36 Pr(Buy|90) = (0.90 x 0.40) + (0.10 x 0) = 0.54

low

0.50 90

0.90

Liquidity Trader

Insider

Using Bayes rule to calculate the sell at ask based on conditional probabilities: Pr(Sell|High)Pr(High) Pr(High|Sell) = [Pr(Sell|High)Pr(High)] + [Pr(Sell|Low)Pr(Low)] Pr(110|Sell) = Pr(110|Sell) = Pr(110|Sell) = 0.36 x 0.50 [0.36 x 0.50]+ [0.46 x 0.50] 0.18 0.18 + 0.23 0.18

0.41 Pr(110|Sell) = 0.439 Pr(90|Sell) = 1- 0.439 = 0.561 Therefore, the bid price is: Ask Price = (0.439 x 110) + (0.561 x 90) = 48.29 + 50.49 = 98.78

Using Bayes rule to calculate the buy at bid based on conditional probabilities: Pr(Buy|High)Pr(High) Pr(High|Buy) = [Pr(Buy|High)Pr(High)] + [Pr(Buy|Low)Pr(Low)] 0.64 x 0.50 Pr(110|Buy) = [0.64 x 0.50]+ [0.54 x 0.50] 0.32 Pr(110|Buy) = 0.32 + 0.27 0.32 Pr(110|Buy) = 0.59 Pr(110|Buy) = 0.5424 Pr(90|Buy) = 1- 0.5424 = 0.4576 Therefore, the bid price is: Bid Price = (0.5424 x 110) + (0.4576 x 90) = 59.664 + 41.184 = 100.848

We notice that the ask price is considerably lower than starting price of 100 [= (0.50 x 110) + (0.50 x 90) = 55 + 45]. In contrast, the bid price is considerably higher than the starting price of 100. This is due to the fact that the bid price follows a buy order. In addition, the buy orders are less informative than sell orders. That is because the noise traders are more likely to buy more than to sell. If noise trading is symmetrical, the bid and the ask price is also symmetrical around the starting price.

Noise traders put in a buy order or a sell order for a given quantity, with equal probability. An insider puts in a buy order if he has positive information and a sell order if he has negative information, again for a given quantity. There is one insider for every nine noise traders. The current price of the stock is 100, and positive information implies the price is 110 and negative information 90. Work out the bid-ask prices of a risk neutral market maker who clears the market.

Limitations of Glosten-Milgrom model In the Glosten-Milgrom framework, the bid and the ask quotes respond to the relative arrival rates of buy and sell orders. When the buy and sell orders are balanced, the market maker keeps his bid-ask spread tight. This suggests that the insider trading is unlikely. However, in the case of imbalanced orders, the market maker quotes ask price high if there is buy bias and bid price low if there is sell bias. This poses dilemma for insiders. If insider trades in small quantities, he makes a large profit per trade, as prices remain uninformative. The cost of doing this is to forego the quantityrelated profits. If insider trades in large quantities, he makes bigger impact on price, which reveals more accurately about the information of the insider. In this case, he foregoes price-related profits. Glosten-Milgrom model does not address the question how to balance these two. To answer this question, Kyle model should be used because it involves more than the process of revising beliefs.

Kyle model is the concept of equilibrium as there are two players. One player is the insider, who trades against market maker. The other player is the market maker, who seeks to infer from the trading quantities the information of the insider. The insiders trading strategy needs to be the optimal one given the market makers inference. This inference needs to reflect correctly the trading strategy of the insider. Kyle model is based on the single period model. It assumes a normally distributed asset price x, which (irrational) noise traders trade in a normally distributed quantity y. This unrealistic assumption made enables us to obtain the result of the optimal insider trading in terms of algebra. x ~ N(0,2) (1) y ~ N(0,2) (2) where N denotes the normal distribution; the first argument denotes the expectation (e.g. expected asset price is zero and expected quantity is zero); the second argument denotes the variance.

Kyle model also assume that insider traders have better information than noise traders. This means that insider traders know the exact value of the asset. Insider traders are assumed to be risk neutral. The insider trader trades a quantity z. In this case, the aggregate market order, q is such that: q = y + z (3) Kyle model assumes that market maker is operating in a perfect competitive framework. In this case, market maker is not able to make any monopoly profits. This aggregate market order, q is observable to the market maker. He cannot observe y and z separately. Market maker sees a large aggregate order of buy (sell) orders. He does not know whether it is caused by unexpected large number of noisy buy (sell) orders or by unexpected large number of insider trades. With this observation of the aggregate market order, he determines the market-clearing price, p such that: p = E(x|q) (4) Equation (4) implies the market-clearing price, p equal expected asset price, x conditional on the aggregate market order, q.

A linear equilibrium consists of two functions such that z = bx (5) p = dq (6) where b and d are constant. The insiders quantity, z maximises the insiders profits given the equation (6), and market-clearing price, p, given the equation (5). Suppose the insider uses a linear strategy bx. Then, the aggregate order flow is such that: q = bx + y (7) where y is the normally distributed error term, which is the demand by noise trader. The regression of the asset value x on the aggregate order flow, q produces the relationship, such that: x = dq + y (8) where d is the coefficient in this regression.

When forecasting x based on observations of q, the market maker finds the optimal forecast such that: E(x|q) = dq (9) where the regression coefficient, d is given by covariance between q and x over the variance of q. Cov(q,x) d= (10) Var(q) Substitute equation (7) into equation (10): Cov(bx+y,x) d= (11) Var(bx+y) Expand equation (11): Cov(bx,x) + Cov(y,x) d= (12) Var(bx)+Var(y) Since Cov(y,x) = 0, rewrite equation (12): Cov(bx,x) d= (13) Var(bx) + Var(y)

Rearrange equation (13): bCov(x,x) d= 2 (14) b Var(x) + Var(y) Since Cov (x,x) = Var (x), rewrite equation (14): bVar(x) d= 2 (15) b Var(x) + Var(y) Var(x) = 2 and Var (y) = 2; rewrite equation (15) b2 d= 2 2 (16) b + 2 Substitute equation (15) into equation (9) b2 E(x|q) = 2 2 q (17) b + 2 Equation (17) is the function for the market makers response to aggregate demand.

The insider observes asset price, x first, then he decides his optimal trading quantity, z. For each unit traded, he maximises his profit such that: (x) = z(x - p) (18) Substitute equation (6) into equation (18): (x) = z(x - dq) (19) Substitute (7) into equation (19): (x) = z(x - d(y + z)) (20) Equation (20) states that insiders profit depends on asset price, x, insiders quantity, z, and noise traders quantity, y. The insider cannot observe the noise insiders quantity, y. Thus, he takes his expectation over all outcomes of y.
Take expectation on equation (20): E(x) = z(x - dz) where E(y) = 0 Insider trader is interested in maximising his expected profits on his trading. Expand equation (20): E(x) = zx - dz2 Differentiate equation (22) with respect to z: dE(x)/dz = x - 2dz Set equation (23) equal to zero: x - 2dz = 0 Rearrange equation (24): x-2dz = 0 x = 2dz z = x/2d (21)

(22) (23) (24) (25) (26) (27)

Substitute equation (16) into equation (27): x z= b2 2 2 2 b + 2 Rearrange equation (28): b22 + 2 x z= 2 2b Since z = bx, the constant b is given by: b22 + 2 b= 2b2 Rearrange equation (30): 2b22 = b22 + 2

(28)

(29)

(30)

(31)

Subtract both sides of equation (31) by b22: b22 = 2 Rearrange equation (32): 2 2 b = 2 Take square roots on both sides of equation (33): b = Substitute equation (34) into equation (5): z = x Rearrange equation (27): 2d = x/z d = x/2z Substitute equation (35) into equation (38) x d = 2x d = 2 Substitute equation (39) into equation (6): p = 2 q

(32)

(33)

(34)

(35) (36) (37) (38)

(39)

(40)

According to the equation (35), the greater the ratio of the variance of noise trade to that of the asset value, therefore, the more aggressively the insider trades on the basis of his information. Insiders are able to trade aggressively on their private information because noise trading camouflage insiders trading. This can be done by spreading the trades over time. Because of this, based on equation (40), the greater ratio leads to a deeper market however, as the market makers prices respond less to the volume of demand. This is because the likelihood of the order being that of a noise trader, rather than an insider, is greater. Therefore, the more noise trading makes it more difficult for the market maker to extract the signal of the insider trading from the noise. By assumption, the market maker sets the asset price in a way that gives him zero expected profit. By implication, the expected profits of the insider equal the expected losses of the noise traders. In other words, it is the noise traders, not the market maker, that lose, on average, from the presence of the insider. The conclusion is that from equation (20),the greater the number of noise traders is, the greater the profits of the insider is. By implication, the total losses of the noise traders are greater. However, an individual noise traders expected loss is less.

Example of Kyle Model (Extracting from IM Mock Exam 2008) Consider a scenario where insider trader has private information. This private information suggests that a takeover announcement will be made next week and this will boost the stock price of a company by 20%. Suppose that the current price is 100. The market maker thinks it is equally likely that such an announcement will be made as a profit warning. This implies that the price will be reduced by 20%. The market maker thinks that some announcement will be made regardless, however, so there is no chance that price will not move. Suppose there is one noise trader present who will either buy 1,000 shares of the companys stock, or sell 1,000 shares with equal probability. The market maker cannot distinguish insiders order from that of the noise trader. If the insider trader wants to submit a buy order of 5,000 shares, it will reveal for sure that this buy order of 5,000 shares is insiders. This is because it is different from what noise trader usually does. This means that the market maker sees two orders - one of 1,000 shares on the sell side or buys side, and one of 5,000 shares on the buy side. Since insider trader trades with perfect information, the market maker will put all the weight on your order, and will set the ask price at, say, 120. In this case, the insider trader makes no profit on his trade.

In order to camouflage the insiders order, he would trade in exactly the same quantities as the noise trader. In other words, he buy 1,000 shares if information is good and he sell 1,000 shares if the information is bad. In this case, the market maker sees three possibilities. First, there are two buy orders of 1,000 shares each. Second, there are one buy order of 1,000 shares and one sell order of 1,000 shares each. Third, there are two sell orders of 1,000 share each.

In this second possibility, the market maker cannot distinguish who the noise trader is and who insider is just from looking at the order. From the market makers point of view, there is half chance the insider has positive news and half chance he has negative news. Therefore, first possibility has its value of 0.25; second possibility has its value of 0.5; third possibility has its value of 0.25. From the insiders point of view, however, who knows whether he has positive news or negative news. Thus, he has first possibility and third possibility. First and third possibilities have value of 0.5.

The expected profits for the insider is, therefore: Good news: Profit = [ x (120-100) x 1,000] + [1/2 x (120-120) x 1,000)] = 10,000 Bad news: Profit = [ x (100-80) x 1,000] + [1/2 x (80-80) x 1,000)] = 10,000 Alternatively, Good news: Profit: 1/2 x (120-100) x 1000 = 20,000 Bad news: Profit: 1/2 x (100-80) x 1000 = 20,000 Expected profit = [50% x 20,000] + [50% x 20,000] = 10,000 These mean that the insider makes 10,000 expected profit regardless of his information.

Stealth trading hypothesis Empirical evidence produced by Barclay and Warner support the above demonstration of Kyle model. Barclay and Warner look at the transaction data to explore the characteristics of the trade that tend to move prices the most. Whether an informed trader reaches his desired share position in one or multiple trades should depend on two factors. First is the expected price impact of the trades (i.e. price concessions). Price concessions include a temporary component as compensation for the market maker, and a permanent component reflecting any new information revealed by the trade. Both of these components increase with trade size. This raises the possibility that a given position can be obtained with a smaller price concession if the trades are broken up spread over time. Second, an offsetting cost is that spreading trades over time delays the acquisition of the desired position. In addition, this cost also increases the likelihood that the price will move against the trader if his information is revealed publicly or by other informed trades. Moreover, most brokerage firms offer a fixed cost per trade, which further shifts a traders strategy in favour of one trade.

Medium share positions are likely to be achieved in a single trade because the price concession for a medium-size trade is small. Thus, any potential reduction in price concessions is unlikely to offset the delay costs from breaking up a medium-size trade. Large share positions are likely to be broken up, however, because the price concession for a large trade by an informed trader is substantial. It is because these large share positions are likely to be reported to the authorities, such as Security Exchange and Commission (SEC). In this case, uninformed traders have incentives to reveal their identities to reduce the information-related price concessions associated with their trades. If a large-block trader cannot be certified as a liquidity trader, he faces a large price concession. Thus, Barclays and Warner hypothesize that an informed trader can achieve a large change in share position by spreading several medium-size trades over time. This results in a significantly smaller total price concession. In many cases, the savings from smaller price concessions on medium-size trades will offset any delay costs. Their finding is that the very small trades and the very large trades do not move the price a lot. In contrast, the average sized trades tend to move prices. This suggests that insiders attempt to hide their information when submitting their orders. This is so-called the stealth trading hypothesis. The impact this has on security trading is that private information can be expected to be released and embedded in stock markets slowly implying that markets are unlikely to be strongly efficient.

Why market microstructure matters to investment analysis Market microstructure area suggests that the prices of financial assets may reflect the underlying fundamental value of the asset. In addition, they may also contain components that are specific to the environment in which they are traded. There are two factors. First, the prices tend to become depressed when there is temporarily a lack of buyers in the market. Moreover, the prices tend to become inflated when there is a temporarily a lack of sellers. Second, the bid-ask spread between buy and sell transactions may become large when there is possibility that traders with superior information operate. A relatively unsophisticated trader with poor information is likely to incur adverse selection costs of trading against more sophisticated traders. It is extremely difficult to detect and protect unsophisticated trader against sophisticated, well-informed traders. This is because sophisticated, well-informed traders can use such techniques to hide their trading activities from other market participants. In this case, unsophisticated traders will benefit only if they buy and hold a portfolio for longterm strategy.

Q3C 2A 2008 Q2a, Q4A ZA 2009 Q4A ZB 2006 Q1A and Q1B ZB 2007 Q7B ZB 2008 Q3b, Q3c and Q8A ZB 2009 Q2C ZB 2010 Q3A ZB 2011