1 / 23

# Market Microstructure Bid-Ask Spreads and PIN Daniel Sungyeon Kim - PowerPoint PPT Presentation

I am the owner, or an agent authorized to act on behalf of the owner, of the copyrighted work described.

Download Policy: Content on the Website is provided to you AS IS for your information and personal use and may not be sold / licensed / shared on other websites without getting consent from its author.While downloading, if for some reason you are not able to download a presentation, the publisher may have deleted the file from their server.

- - - - - - - - - - - - - - - - - - - - - - - - - - E N D - - - - - - - - - - - - - - - - - - - - - - - - - -
Presentation Transcript

into what two components?

Transaction cost component

• Transaction cost component can be further decomposed into three pieces:
• Inventory risk component – compensates dealers for bearing price risk their inventory
• Order processing cost component – compensates dealers for their normal cost of doing business
• Monopoly profits component – extra profits that can be extracted by monopoly power

Recent estimate by Henker and Martens:

Inventory risk = 17% of spread = 1.2 cents

Order processing = 65% of spread = 4.5 cents

Monopoly profits = 3% of spread = 0.2 cents

What are the two explanations for adverse selection component?

Information perspective

Accounting perspective

Figure 14-1
• Ask0 = V0 + (1/2) Adv Selection + (1/2) Transaction Cost
• Bid0 = V0 – (1/2) Adv Selection – (1/2) Transaction Cost
• Figure directly shows information perspective:
• If sell trade, value decreases from
Figure 14-2

This becomes the new midpoint:

Bid1= V1– (1/2) Adv Selection – (1/2) Transaction Cost

If next trade = sell, value decreases from

Change in value = V1–V0 = (1/2) Adv Selection

Vs. Transaction Cost=Transitory Component of the spread

That is, Ask0 - went away  did not become part of change in value

If the market is Efficient = reflects all available info,

then value changes are unpredictable = Random Walk

“Most Important Lesson in this Book for Most Readers”

Uninformed traders lose to informed trader regardless of whether they use a limit order or market order

Example: Ask = 30.10, Bid = 30.00, informed have good news that stock is worth 35.00

(1) Uninformed submits limit sell at 30.10

 informed buys at 30.10, price rises to 35.00

 uninformed sold at 30.10 & missed price rise

(2) Uninformed submits limit buy at 30.00

price rises to 35.00

uninformed limit buy doesn’t execute & misses price rise

(3) Uninformed submits market buy or market sell

 pays the spread, which is wider due to adv select comp

Easley, Keifer, O’Hara, and Paperman

Develop a simple, classic model of adverse selection

Can estimate how much informed trading in any stock

 PIN = Probability of INformed trade

= % of traders that are informed

PIN Computation

Chance of Informed Sell =

PIN= % of traders that are informed

PIN Model Dynamics

Some traders are informed and others are uninformed

 Market makers don’t know which

 Every trade causes a price reaction

Every sell causes a lower bid and ask

PIN Sampler

m

e

d

a

PIN

Vega

PIN parameters

year-by-year

PIN Sampler

Agudelo

In Indonesia,

who is more

informed:

foreigners

or locals

PIN(foreigners)

vs. PIN(locals)

PIN Sampler

Easley,

Engle,

O’Hara,

Wu

Dynamic PIN

model

PIN estimates

for 16 stocks

PIN Sampler

Easley,

O’Hara

Modified

Version of

PIN =

VPIN

during for

the 2010

Flash

Crash