Spread Reduces Costs of Dealing

Order processing costs
1. Financing for inventory
2. Wages
3. Rent
4. Membership fees
5. Telecommunications
6. Clearing and settlement
7. Accounting
8. Utilities
Inventory holding costs
1. Inventories are too low or clients are net buyers
2. Inventories are too high or clients are net sellers
3. Expensive to quickly adjust inventory position
4. Regular turnover desired
Adverse selection costs
1. Trade is equally likely to occur at bid or ask
  1. No knowledge whether trader is informed or uninformed
2. Trading occurs between informed and uninformed investors
3. Kyle's types of traders
  1. Informed traders with perfect info
    1. Problem: Profit maximisation
  2. Uninformed noise traders
    1. Tries to discern trades from informed traders
  3. Single dealer as intermediary
    1. Price adjustment
    2. Well informed
      1. Lower adverse selection costs
      2. Hold larger inventory
      3. Hold longer lived inventory
      4. Earn larger realised spreads
      5. Value traders
        Trade when prices diverge significantly from fundamental values
    3. Poorly informed
      1. Turn over positions quickly
      2. Earn smaller realised spreads
4. Reducing adverse selection costs
  1. Time slicing
  2. Adjust quotes
  3. Buy at ask
  4. Do nothing

Resource summary

	Created by Vhia Rose over 10 years ago