Capital Markets – Dynamic Trading

Flashcards about the structure and regulation of financial markets, focusing on capital markets and dynamic trading.

What are the key determinants of the bid-ask spread under asymmetric information according to the King-Roell model?

The bid-ask spread is determined by the fraction of informed clients (q) and the uncertainty about the true value of the stock (VH − VL).

What happens in the King-Roell model when q = 0 (no insiders)?

The market clears with zero spread (market efficiency), and the price equals the expectation (price efficiency). Pa = Pb = μ.

What happens in the King-Roell model when q = 1 (only insiders)?

The bid-ask spread equals the value spread (VH − VL), and the market collapses because even the insiders have no incentive to trade.

What is a consequence of insider trading when 0 < q < 1 in the King-Roell model?

The bid-ask spread may prevent some liquidity trades, leading to adverse selection and market inefficiency.

What is a critique of the static King-Roell Model?

Trades occur only once, so prices do not evolve.

According to the Glosten and Milgrom model, what happens as trades accumulate?

As trades cumulate, the price converges on the true value, the spread becomes zero, and both market and price efficiency are achieved.

What useful function do insiders perform in the Glosten and Milgrom model?

Insiders push prices in line with the true value, which gives a favorable view of their activities.

What are the initial values considered in the first trade of the Glosten and Milgrom model?

The prior expectation, μ1, and the prior probability of a high value outcome, p1, which is initially 0.5.

How is the expectation μ2 calculated after the first trade in the Glosten and Milgrom model?

μ2 = p2VH + (1 − p2)VL, where p2 is the posterior probability of a high value after the first trade.

If the first client buys in the Glosten and Milgrom model, how does the probability of a high value (p2) change?

𝑝2 = 𝑝1 + 𝑞/2 > 𝑝1. The probability of a high value increases.

What is the formula for the second trade ask price (Paa) in the Glosten and Milgrom model, conditional on the first and second client being a buyer?

Paa = 𝜇2 + [𝑞(𝑞+1) / (𝑞(𝑞+1)+(1−𝑞))] (VH −𝜇2)

What is the formula for the second trade bid price (Pab) in the Glosten and Milgrom model, conditional on the first client being a buyer and the second a seller?

Pab = [1 / (1+𝑞)] 𝜇2 + [𝑞 / (1+𝑞)] 𝑉𝐿

What is the relationship between Pab and Pba if μ2 = Pa = μ1 + (VH − VL) q⁄2?

Pab = μ1 = Pba

What is the second trade bid price when the first and the second trade client is a seller?

Pbb = μ2 + [q(q+1) / (q(q+1)+(1−q))] (VL − μ2) < μ2 = Pb

According to the Glosten and Milgrom model, what happens as trades accumulate?

As trades cumulate, the price converges on the true value, the spread becomes zero, and both market and price efficiency are achieved.

In the Glosten and Milgrom model, what conditions are met in the long term?

In the long term we have both market efficiency (zero spread) and price efficiency (price equals true value)

In the Glosten and Milgrom model, how many insiders are needed to get the outcome of market and price efficiency?

Only a few insiders are needed to get this outcome.