1. 1 Chapter 5 Secondary Market Making

2. 2 A.Secondary Market Making – Dealer/Broker Activity 1. Give financial claims greater liquidity  Investors  Issuers  Investment Bankers 2. 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 3. Dealing vs. Brokering  Bid-ask spread  commission

3. 3 B.Dealers 1. Instruments  Traders in dealer markets – swaps, mortgage-backed products, etc.  Traders in exchanges – futures  Traders in dealer markets and exchange markets 2. Functions  Provide a quote  Size a quote 3. 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. 4 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 5. Inventory financing  Repo market

5. 5 C.Brokers 1. Functions  Fill orders market order vs. limit order  Floor trading order book

6. 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. 7 2. 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. 8 D.Speculators 1. 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. 2. Speculative methods  Fundamental analysis  Technical analysis 3. Trading methods  Absolute value trading  Relative value trading  Rating forecasting  Complex forecasts

9. 9 E.Arbitrager Arbitrage is defined as the simultaneous taking of positions in two or more markets in order to exploit pricing aberrations among them. 1. 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.