Chapter 16 Value Traders. Value traders supply liquidity Uninformed traders cause prices to deviate from fundamental values Dealers mistakenly respond.

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Presentation transcript:

Chapter 16 Value Traders

Value traders supply liquidity Uninformed traders cause prices to deviate from fundamental values Dealers mistakenly respond to order flow Dealers adjust prices for inventory reasons Traders alone can cause prices to deviate from fundamental values in order-driven markets How value traders respond Supply liquidity (i.e., offer limit orders) to the uninformed liquidity demanders directly Supply liquidity indirectly via dealers

Supply liquidity to the uninformed liquidity demanders indirectly via dealers: how? Uninformed traders sell to dealers → Dealers accumulate inventories → Dealers adjust (lower) prices (because they do not know whether traders are informed or not → Prices fall below fundamental values → Value traders trade (they take liquidity away from the dealers in the form of immediacy, but simultaneously supply liquidity in the form of size (or depth).

Outside spread and its determinants The prices at which a value trader is willing to trade (they rarely quote these prices) Risk of value trading Adverse selection risk – Informed traders The winner’s curse problem  Buy (sell) overvalued (undervalued) instruments  Market impact Cost of value trading Research expenditures

Outside spreads Prices that value traders are happy to accept when sell (A) Prices that value traders are willing to pay when buy (B) Outside spread = difference between A and B

More on the winner’s curse Arises because the highest bidders tend to be buyers who overestimate values To avoid the winner’s curse, bidders should lower their bids more when bidding against many buyers To avoid the winner’s curse, bidders should lower their bids more when values are hard to estimate You do not want to compete against foolish traders

Outside spreads are much wider than dealer spreads due to The speed at which they trade Size of positions (inventory risks) Research costs Exposure to adverse selection Exposure to the winner’s curse Total trading volume Dealers earn the entire spread (from a round-trip trade) while value traders earn half the outside spread at most

Value traders vs. news traders Both are informed traders Value (news) traders offer (take) liquidity Value traders should offer liquidity only to uninformed liquidity traders, not to news traders News traders must make sure that they are trading on fundamental information that is not yet in the price