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Chapter 5

Chapter 5. Secondary Market Making. Secondary Market Making – Dealer/Broker Activity. Give financial claims greater liquidity Investors Issuers Investment Bankers Stock return, Liquidity and Order imbalance Order imbalance theory Buyer-initiated order Seller-initiated order

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Chapter 5

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  1. Chapter 5 SecondaryMarket Making

  2. Secondary Market Making – Dealer/Broker Activity • Give financial claims greater liquidity • Investors • Issuers • Investment Bankers • Stock return, Liquidity and Order imbalance • Order imbalance theory • Buyer-initiated order • Seller-initiated order • Information asymmetry in return-volume relation • Speculative trade • Hedge trade • Dealing vs. Brokering • Bid-ask spread • commission

  3. Dealers • Instruments • Traders in dealer markets – swaps, mortgage-backed products, etc. • Traders in exchanges – futures • Traders in dealer markets and exchange markets • Functions • Provide a quote • Size a quote • Reasons to participate • Take profit – bid-ask spread Price vs. Inventory Market Microstructure • Develop and maintain good pricing skills Secondary market making supports primary market making

  4. Managing dealers risks • Identify the risks • Systematic risk • Unsystematic risk • Interest rate risk • Credit risk • Call risk • Prepayment risk • Purchasing power risk • Tax rate risk • Quantify the risks • Natural hedge • Value at Risk (VaR) • Managing the risks • Short or long position • Building blocks • Inventoryfinancing • Repo market

  5. Brokers • Functions • Fill orders market order vs. limit order • Floor trading order book

  6. Other services • Monitor margin accounts • Initial margin vs. maintenance margin • Margin call • Offer investment management service • Process dividends and interest coupon • Assist in structuring portfolios • Real estate • Stock and bonds • Mutual funds • Life insurance policy • Retirement account • Provide research and recommendation

  7. Possible abuses • Bucket shops Securities firms that take customer orders but do not immediately execute them. • Boiler rooms Firms that use high-pressure sales tactics to sell securities. • Churning Excessive trading of a customer’s account to earn commission, especially in discretionary trading account. • Front running Trading ahead of a customer • Poor fills Hold and signal market orders

  8. Speculators • Speculation and manipulation • Speculation：to take a position in anticipation of a change in price level. • Manipulation：to use personal power to affect prices to produce personal gains. • Speculative methods • Fundamental analysis • Technical analysis • Trading methods • Absolute value trading • Relative value trading • Rating forecasting • Complex forecasts

  9. Arbitrager Arbitrage is defined as the simultaneous taking of positions in two or more markets in order to exploit pricing aberrations among them. • Spatial arbitrage • Geographic arbitrage • Temporal arbitrage：program trading cash price vs. forward price • Temporal arbitrage：the cash-and-carry synthetic A cash-and-carry transaction involves the purchase of an instrument and the simultaneous sale of a future contract in order to create a synthetic short-term instrument and to earn low-risk short-term rates.

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