Chapter 5 Secondary Market Making 1 A Secondary

Chapter 5 Secondary Market Making 1

A. Secondary Market Making – Dealer/Broker Activity Give financial claims greater liquidity 1. v v v Investors Issuers Investment Bankers Stock return, Liquidity and Order imbalance 2. v Order imbalance theory v v v Buyer-initiated order Seller-initiated order Information asymmetry in return-volume relation v v Speculative trade Hedge trade Dealing vs. Brokering 3. v v Bid-ask spread commission 2

B. Dealers Instruments 1. v v v Traders in dealer markets – swaps, mortgage-backed products, etc. Traders in exchanges – futures Traders in dealer markets and exchange markets Functions 2. v v Provide a quote Size a quote Reasons to participate 3. v Take profit – bid-ask spread Price vs. Inventory Market Microstructure v Develop and maintain good pricing skills Secondary market making supports primary market making 3

Managing dealers risks 4. § Identify the risks v v v v § Quantify the risks v v § 5. Systematic risk Unsystematic risk Interest rate risk Credit risk Call risk Prepayment risk Purchasing power risk Tax rate risk Natural hedge Value at Risk (Va. R) Managing the risks v Short or long position v Building blocks Inventory financing v Repo market 4

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

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

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

D. Speculators Speculation and manipulation 1. v v 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 2. v v Fundamental analysis Technical analysis Trading methods 3. v v Absolute value trading Relative value trading Rating forecasting Complex forecasts 8

E. 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 1. v v v 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. 9