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Market Microstructure Bid-Ask Spreads and PIN Daniel Sungyeon Kim.

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Presentation on theme: "Market Microstructure Bid-Ask Spreads and PIN Daniel Sungyeon Kim."— Presentation transcript:

1 Market Microstructure Bid-Ask Spreads and PIN Daniel Sungyeon Kim

2 Bid-Ask spread The bid-ask spread can be decomposed into what two components? Adverse selection component Transaction cost component 2

3 Four-way Decomposition of the spread Adverse selection component Transaction cost component can be further decomposed into three pieces: –Inventory risk component – compensates dealers for bearing price risk their inventory –Order processing cost component – compensates dealers for their normal cost of doing business –Monopoly profits component – extra profits that can be extracted by monopoly power 3

4 Four-way Decomposition of the spread Recent estimate by Henker and Martens: Adverse selection = 15% of spread = 1.0 cents Inventory risk = 17% of spread = 1.2 cents Order processing = 65% of spread = 4.5 cents Monopoly profits = 3% of spread = 0.2 cents Total spread = 6.9 cents 4

5 Explanations for Adverse Selection Comp. What are the two explanations for adverse selection component? Information perspective Accounting perspective 5

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7 Figure 14-1 Ask 0 = V 0 + (1/2) Adv Selection + (1/2) Transaction Cost Bid 0 = V 0 – (1/2) Adv Selection – (1/2) Transaction Cost Figure directly shows information perspective: –If buy trade, value increases from –If sell trade, value decreases from 7

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9 Figure 14-2 Suppose there is a buy trade, value increases from This becomes the new midpoint: Ask 1 = V 1 + (1/2) Adv Selection + (1/2) Transaction Cost Bid 1 = V 1 – (1/2) Adv Selection – (1/2) Transaction Cost If next trade = buy, value increases from If next trade = sell, value decreases from Change in value = V 1 –V 0 = (1/2) Adv Selection Adverse Selection = Permanent Component of the spread Vs. Transaction Cost=Transitory Component of the spread That is, Ask 0 - went away did not become part of change in value If the market is Efficient = reflects all available info, then value changes are unpredictable = Random Walk 9

10 Most Important Lesson in this Book for Most Readers Uninformed traders lose to informed trader regardless of whether they use a limit order or market order Example: Ask = 30.10, Bid = 30.00, informed have good news that stock is worth 35.00 (1) Uninformed submits limit sell at 30.10 informed buys at 30.10, price rises to 35.00 uninformed sold at 30.10 & missed price rise (2) Uninformed submits limit buy at 30.00 informed submits limit buy at 30.01 (or buys at 30.10) price rises to 35.00 uninformed limit buy doesnt execute & misses price rise (3) Uninformed submits market buy or market sell pays the spread, which is wider due to adv select comp 10

11 Easley, Keifer, OHara, and Paperman Develop a simple, classic model of adverse selection Can estimate how much informed trading in any stock PIN = Probability of INformed trade = % of traders that are informed 11

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13 PIN Computation Chance of Informed Sell = Chance of Informed Buy = Chance of Informed Trade = Chance of Uninformed Trade= PIN = % of traders that are informed 13

14 A PIN example DayBuysSells 15349 27451 34878 45150

15 PIN Model Dynamics Some traders are informed and others are uninformed Trading is anonymous Market makers dont know which trader is informed vs. uninformed Every trade causes a price reaction Every sell causes a lower bid and ask Every buy causes a higher bid and ask 15

16 16 = PIN

17 PIN Sampler Vega PIN parameters year-by-year 17 e m ad PIN

18 PIN Sampler Agudelo In Indonesia, who is more informed: foreigners or locals PIN(foreigners) vs. PIN(locals) 18

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20 PIN Sampler Easley, Engle, OHara, Wu Dynamic PIN model PIN estimates for 16 stocks 20

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22 PIN Sampler Easley, De Prado, OHara Modified Version of PIN = VPIN during for the 2010 Flash Crash 22

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