24

FINANCIAL RISK MANAGEMENT

table. Buyer 1s knowledge of this market is superior to buyer 2s, and

both have superior knowledge compared to the seller. This can be seen
by the correlations between realized value and each partys estimate of
transaction value (83.3% for buyer 1, 72.2% for buyer 2, and 63.2%
for the seller). The consequences of this informational advantage are that
both buyer 1 and buyer 2 make a profit at the expense of the seller in direct negotiations, and that buyer 1s profit in this situation is higher than
buyer 2s profit.
In the direct negotiation situation, we assume that the buyer, being
risk averse, has successfully biased his bids down to be on average lower
than the realized value, and the seller, being risk averse, has successfully
biased his asked prices up to be on average higher than realized value.
We assume no transaction takes place if the buyers bid is lower than the
sellers asked. If the buyers bid exceeds the sellers asked, we assume the
transaction takes place at the average price between these two prices. As
a result, buyer 1 has a total P&L of +1.09, and buyer 2 has a total P&L
of +0.55.
Now consider what happens in the auction when the buyers have to
compete for the sellers business, a situation very typical for market making
firms that must offer competitive price quotations to try to win customer
business from other market makers. The seller no longer relies on his own
estimate of value, but simply does business at the better bid price between
the two firms. Even though both firms continue to successfully bias their
bids down on average from realized values, both wind up losing money in
total, with buyer 1 having a P&L of 0.86 and buyer 2 having a P&L of
0.84. This is because they no longer have gains on trades that they seriously
undervalued to balance out losses on trades that they seriously overvalued,
since they tend to lose trades that they undervalue to the other bidder. This
illustrates the winners curse.
The spreadsheet WinnersCurse on the course website shows the consequences of changing some of the assumptions in this example.

2.5

MARKET MAKING VERSUS POSITION TAKING

An important institutional distinction between participants in the financial

markets that we will refer to on several occasions throughout this book is
between market making and position taking:

Market making (also called book running or the sell side) consists of
making twoway markets by engaging in (nearly) simultaneous buying and selling of the same instruments, attempting to keep position