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Market Microstructure Daniel Sungyeon Kim. Types of Arbitrage. I’ll give you some examples of arbitrage and you tell me what type of arbitrage they are ( pure arb vs. speculative arb , etc.) Arbs buy low, sell high  profit on the price difference

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types of arbitrage
Types of Arbitrage
  • I’ll give you some examples of arbitrage and you tell me what type of arbitrage they are (pure arbvs. speculative arb, etc.)
  • Arbs buy low, sell high  profit on the price difference

Ex: TSE GM = $35.20  sell high (converted to US $)

NYSE GM = $35.00buy low

profit = $0.20

  • Ex: Corn in France = $7.00 / bushel  sell

Corn in US = $6.00 / bushel  buy, ship

Shipping cost = $0.60 / bushel

Profit = $0.40 / bushel

  • Q: What kind are they: pure arb or speculative arb?
more on types of arbitrage
More on Types of Arbitrage
  • Here is an example of speculative arb
  • Pairs trading:
    • GM is underpriced (your value > market price)
    • Ford is overpriced (your value < market price)
  • Spec arb = (+$1 million) in GM & (-$1 million) in Ford
  •  if correct: GM up and Ford down  profit
  • Q: How much marketwiderisk does this bet have?
more on types of arbitrage1
More on Types of Arbitrage
  • Here is an example of speculative arb
  • Pairs trading:
    • GM is underpriced (your value > market price)
    • Ford is overpriced (your value < market price)
  • Spec arb = (+$1 million) in GM & (-$1 million) in Ford
  •  if correct: GM up and Ford down  profit
  • Q: How much auto industry risk?
more on types of arbitrage2
More on Types of Arbitrage
  • Here is an example of speculative arb
  • Pairs trading:
    • GM is underpriced (your value > market price)
    • Ford is overpriced (your value < market price)
  • Spec arb = (+$1 million) in GM & (-$1 million) in Ford
  •  if correct: GM up and Ford down  profit
more on types of arbitrage3
More on Types of Arbitrage
  • Portfolio generalization:
    • Low tech stocks are underpriced (your value > market price)
    • High tech stocks are overpriced (your value < market price)
  • speculative arb= (+$1 million) in low tech portfolio and . (-$1 million) in high tech portfolio
  • Q: How much marketwide risk does this bet have?
application to the flash crash
Application to the Flash Crash

Suppose heavy selling pressure on S&P 500 stocks that pushes the price down

but no selling pressure in mid-cap and small-cap stocks

Q: What should speculative arbitrageurs do?

more on types of arbitrage4
More on Types of Arbitrage

Q: Going back to the first two examples (GM and Corn), are they cross-instrument arbor intermarketarb?

more on types of arbitrage5
More on Types of Arbitrage

Here is an example of Cross-instrument arb:

Soybean crush = beans can be crushed and made into oil and meal tight relationship: beans and oil & meal

cost to crush

Q: How do you arb, if beans are cheap?

more on types of arbitrage6
More on Types of Arbitrage

Here is an example of Cross-instrument arb:

Soybean crush = beans can be crushed and made into oil and meal tight relationship: beans and oil & meal

cost to crush

Q: How do you arb, if beans are expensive?

more on types of arbitrage7
More on Types of Arbitrage
  • Index arbitrage
  • Based ontight relationship: S&P 500 Stock Index
  • S&P 500 Stock Index Futures Price
  • “Cost of Carry” = “Spot-Futures Parity” – this pricing equation tells us the relationship should be:
  • (S&P 500 Stock Index Futures Price)

= (S&P 500 Stock Index) * (1 + Riskfree Rate)^(Time to Maturity)

  • based on the Time to Maturity of the Futures contract
  • Deviations from Cost of Carry arbopportunity
price convergence
Price Convergence

At maturity, the Time to Maturity = 0,  S&P 500 Stock Index Futures Price = S&P 500 Stock Index

called Price Convergence

Price Stock Index Futures Price

Stock Index

Time Maturity

index arbitage
Index Arbitage
  • If cost of carry deviation before maturity is greater than transaction costs, then initiate arbitrage  gain profit
  • At maturity, close out position  zero profit at maturity because of Price Convergence
  • Q: Is this pure arbor speculative arb?
price vs quantity characterization
Price Vs. Quantity Characterization
  • Price characterization: arbitrageurs buy low and sell high  brings prices together
  • Quantity characterization: arbs move assets and liquidity from one market to another
  • Going back to our earlier examples:
  • Arbsmove GM shares from NYSE to TSE
  • Arbs move corn from US to France
  • Connecting two markets that would otherwise be separate
  •  combines the liquidity of the two markets
gatev goetzmann and rouwenhorst
Gatev, Goetzmann, and Rouwenhorst

Q: What is their “pairs” investment strategy?

kennecott and uniroyal
Kennecott and Uniroyal
  • Kennecott = cooper mining company
  • Uniroyal = variety of industrial products, particularly tires
  • Not clear why they should tract each other
  • Day 8 = open position
  • Q: Which do you buy and which do you sell on day 8?
  • Buy Uniroyal and sell Kennecott
  • Buying “loser” and selling “winner”  contrarian strategy
  • Day 33 = prices converged  close position
  • Do many times over 6 months (sometimes Uniroyal is lowest, so you buy Uniroyal and sometimes Kennecott is lowest, so you buy Kennecott)
  • Q: Is this fundamental analysis or technical analysis?
pairs trading
Pairs Trading

Pairs traders might be disciplined investors who exploit undisciplined over-reaction by other investors

“Self-financing” strategy = sell short stock A, use proceeds to buy stock B strategy pays for itself with no extra money needed typical of what hedge funds do

bowen hutchinson and o sullivan
Bowen, Hutchinson, and O’Sullivan

Universe: FTSE 100 stocks on the London Stock Exchange

Q: What is their “intra-daypairs” trading strategy?

exhibit 1
Exhibit 1

Clearly Barclays and the Lloyds Banking Group are moving together.

Q: Does this make sense?

Q: What units of time are graph here?

exhibit 2
Exhibit 2

Q: At the first opportunity, which stock do you buy vs. sell?

exhibit 21
Exhibit 2

The gap opens and closes three times – spec arb hopes to exploit transitory price deviations – due to “overreaction” or to temporary imbalance of buyers and sellers

The fourth time big negative shock to Lloyds and no tendency to close the gap –might be permanent price shock – due to news  gap might never close

exhibit 3
Exhibit 3

Comparing gap to open = 2 stddev vs. 3 stddev

 average price deviation is smaller, but average round trips is larger

exhibit 4
Exhibit 4

Returns with 2 stddev triggers

Q: How sensitive are the returns to transaction costs?

exhibit 5
Exhibit 5

Returns with 3 stddev triggers

Q: How sensitive are the returns to transaction costs?

exhibit 6
Exhibit 6

Returns to waiting one houron 3 stddev triggers

Q: How sensitive are the returns to waiting one hour and transaction costs?

summary
Summary

Returns on high-frequency pairs trading is very sensitive to speed and to transaction costs

informed trading
Informed Trading

We know that insider information= Illegal to trade on

Q: What private information is legalto trade on?

informed trader types
Informed Trader Types

Q: What are the four types of informed trading, what they trade on, and the impact that eachtype has on prices

impact on market efficiency
Impact on Market Efficiency
  • Q: What impact does legal informed trading have on market efficiency?

Eugene Fama, developed Market Efficiency theory and evidence

bessembinder maxwell and venkataraman
Bessembinder, Maxwell, and Venkataraman
  • Q: What is TRACE?
  • Financial Industry Regulatory Authority
trace
TRACE
  • Corporate bonds trade in a fragmented dealer market
  • Before TRACE: the market was very opaque price were not reported publicly
  • After TRACE: Must report bond price to NASD within 75 minutes of trade info was published on NASD web site with a 4 hour delay (not exactly “real time”!)
  • Applies to all bonds with issuance size = $1 billion or greater
  • Implemented July 1, 2002
half spreads on trace bonds
Half Spreads on TRACE Bonds
  • Data: 6 months before and 6 months afterimplementation
  • Bonds covered by TRACE and those not
  • Don’t observe bid-ask prices, but DO know which are buys vs. sells  imply transaction costs from regression
  • Change in price = Change in Q + other factors
  • Q = 1 for a buy at implied ask
  • = -1 for a sell at implied bid
  • Coefficient on Delta Q =effective half spread
spill over effect on non trace bonds
Spill-over Effect on Non-TRACE Bonds

Table 3 (not included)

Spill-over effect on Non-TRACE bonds 15% reduction in trading costs

edwards harris and piwowar
Edwards, Harris, and Piwowar
  • Aggregate value Corporate Bonds = Stocks
  • By Jan 2003, all OTC bond trades report to TRACE, not just $1Billion or greater
  • Sample: All TRACE reported trades from Jan 2003 – Jan 2005
  • 12.3 million trades worth $9.3 Trillion
  • Under pressure, NASD phased in “real-time” reporting = within 15 minutes by Jan 2005
  • They examine trading costs by size, credit rating, etc. and by transparent vs. opaque
transaction costs for various classifications
Transaction Costs for Various Classifications
  • Q: What do we see in Figure 3, Panel A?
  • Q: What do we see in Figure 3, Panel B?
  • Q: What do we see in Figure 3, Panel C?
  • Q: What do we see in Figure 3, Panel D?
barber and odean
Barber and Odean

Consider the individual investor’s buying decision

Could buy any one of thousands of possible stocks

Q: How to they suggest that individuals make a buying decision? How do they narrow the field?

barber and odean1
Barber and Odean

Consider the individual investor’s selling decision

Individual investors could short sell any one of thousands of possible stocks

Short-selling = borrow any stock from investment banker,

sell it, later, buy it back, and return it

Q: Do individuals do very much short-selling?

individual investor decisions
Individual Investor Decisions
  • Q: So if you don’t short-sell, what stocks can you sell?
  • How to they suggest that individuals make a selling decision?
institutional investor decisions
Institutional Investor Decisions

Q: Would institutional investors make a buying decision differently?

more on institutional investor decisions
More on Institutional Investor Decisions

Q: Would institutional investors be more willing to short-sell?

more on institutional investor decisions1
More on Institutional Investor Decisions

Prediction: Individuals act different than institutions

Three proxies for attention-getting stocks:

Abnormal volume = today’s volume – normal volume over prior year (prior 252 trading days)

Yesterday’s one-day return

News appearance

buy sell imbalance by current day s news
Buy-Sell Imbalance by Current Day’s News

Same results for all three ways to measure attention

Individuals buy more attention-getting stocks on:

higher than normal volume days,

extreme positive and negative prior returns,

and news days

barber lee liu and odean
Barber, Lee, Liu, and Odean
  • Comprehensive trade and order data from Taiwan for four years
  • Identifies the trader in five broad groups: individuals, corporations, dealers, foreigners, or mutual funds
  • Questions:
equity total assets
Equity / Total Assets
  • Equity / Total Assets = 24% in full sample
  • Equity / Total Assets Excluding Real Estate = 45% in full sample
  • 52% and 62% for lowest quartile of net worth  stocks are broadly distributed (even among the poorest members of society – again, much different than the US)
returns in event time
Returns in Event Time
  • Institutions gain from trade
  • Vs. individuals lose from trade
  • Part of the gain/ loss is immediate, but rest is over six months
summary1
Summary
  • Individuals lose a huge amount by trading: NT$ 935 billion = $US 32 billion = 2.2% of Taiwan GDP = 3.8% reduction in port. return
  • This is especially true on aggressive trades
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