Lecture 4

Information and Price Formation

• Why do people trade?
• Public information versus private information
• What is the effect of informed trading on price?
• Informational efficiency and prices

• Overview of trading game

Dr. Yuanji Wen Chapter 5 FINA3307

Yuanji.wen@uwa.edu.au Trading in Securities
Markets
NBBO
 What is the NBBO at 9:35?
Quotes
Time Bid Offer Exchange
9:31 70.00 70.10 A
9:32 70.05 70.20 B
9:33 69.90 70.15 C
9:34 70.00 70.15 A
• Answer: 70.05 (B) and 70.15 (A,C)
• What about as of time 9:33?
• A similar exercise: Hasbrouck Ex. 5.1

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Related chapters

 Some of the following slides are drawn from Chapter 8

of Harris (2003)
• The chapter is available on LMS

 Teall, 2018, Chp 5.1 and 5.2

 Hasbrouck, 2020, Chp 5, 10, 12

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What is “price”? How is “price” formed?

 Bids and offers  trading mechanism determines price

• But, how do people determine bids and offers?

• Why do they trade?

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Why do people trade?

 Trading is a zero sum game where the total gains of the

winners are exactly equal to the total loss of the losers.

 Returns is:
• positive for winners – have some comparative advantage.
• negative for losers – must get some other benefit from trading.

 This suggests some

• trade to make a profit (profit motivated)
• trade for other reasons (utilitarian)
• trade to make profits but fail (futile)

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Harris 2003 p199 Figure 8-1
Principals

Utilitarian Profit Motivated Futile

Traders Traders Traders

Investment/Disinvestment
Speculators Dealers
Risk Sharing
Informed Parasitic
Asset Exchanges
Traders Traders
Risk Exchanging
Value-Motivated
Gambling Traders Order Anticipators Bluffers

Tax Reasons Headline Traders

Front
Runners
Information-oriented
Technical Traders
Sentiment-oriented
Technical Traders
Arbitrageurs

Squeezers

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Why do people trade? Utilitarian traders

 Trade because they expect to obtain some benefit from

trading besides trading profit.

 Investment and Disinvestment

• Individuals often need to manage their cash flow, moving
money from one point in time to another.
• Investors are uninformed traders who use the markets to
obtain an unconditional rate of return
– Real risk-free+ Risk premium
• Do they know the fundamental value of the asset?
– No
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Why do people trade? Utilitarian traders
 Risk Sharing
• Large projects are often too risky to be financed by individuals
(contrast this to the previous section).
– divide up projects among many owners to distribute risks
– pieces (shares and bonds) are marketed.

 Asset Exchanges
• Traders use many markets to exchange one type of asset (usually
money) for another that has some specific use.

• Examples...
– foreign currency exchange
– spot commodities exchanges

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Why do people trade? Utilitarian traders

 Risk Exchanging (Hedging)

• Hedgers use the financial markets to reduce their exposure to
financial risk.
– When two risks offset each other, one is said to be a hedge for
the other.
– A hedged position has less risk than the separate components.

 Gambling
• Securities markets allow people to take positions on uncertain
future events – likely that some gamblers would also trade financial
instruments.
– Gamblers hope to make money but have no rational reason to
expect to.

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Why do people trade? Utilitarian traders

 Tax Reasons
• The tax system provides opportunity for tax avoidance. Tax
avoiders use the markets to minimise the taxes paid.
– Differences in the tax rates on dividend and capital
gain/losses.
– Deferral of taxable income.

 What do utilitarian traders look for in market structure?

• Liquid markets  Low transaction costs.

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Harris 2003 p199 Figure 8-1
Principals

Utilitarian Profit Motivated Futile

Traders Traders Traders

Investment/Disinvestment
Speculators Dealers
Risk Sharing
Informed Parasitic
Asset Exchanges
Traders Traders
Risk Exchanging
Value-Motivated
Gambling Traders Order Anticipators Bluffers

Tax Reasons Headline Traders

Front
Runners
Information-oriented
Technical Traders
Sentiment-oriented
Technical Traders
Arbitrageurs

Squeezers

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Why do people trade?

 Futile traders
• Noise traders
• Trade on what they falsely believe to be special information
or misinterpret useful information
• If they trade in large numbers and if their trading behaviour
is correlated, they may distort prices from fundamental value.
– Next slide…

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Noise trader
 Example: (Da et al. 2017, RFS)
• Chilean pension investors (individual investors) follow advise from a
advisory firm and switch between equity and bond
• This causes temporary price distortion and increases volatility in equities.

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Harris 2003 p199 Figure 8-1
Principals

Utilitarian Profit Motivated Futile

Traders Traders Traders

Investment/Disinvestment
Speculators Dealers
Risk Sharing
Informed Parasitic
Asset Exchanges
Traders Traders
Risk Exchanging
Value-Motivated
Gambling Traders Order Anticipators Bluffers

Tax Reasons Headline Traders

Front
Runners
Information-oriented
Technical Traders
Sentiment-oriented
Technical Traders
Arbitrageurs

Squeezers

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Dealers

 Dealers are profit-motivated traders who profit by

supplying liquidity to other traders who wants to trade.
• The liquidity service they sell – immediacy- is valuable to
impatient traders.
• Dealers often are known as specialists or market-makers in
stock exchanges and options exchanges.

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Harris 2003 p199 Figure 8-1
Principals

Utilitarian Profit Motivated Futile

Traders Traders Traders

Investment/Disinvestment
Speculators Dealers
Risk Sharing
Informed Parasitic
Asset Exchanges
Traders Traders
Risk Exchanging
Value-Motivated
Gambling Traders Order Anticipators Bluffers

Tax Reasons Headline Traders

Front
Runners
Information-oriented
Technical Traders
Sentiment-oriented
Technical Traders
Arbitrageurs

Squeezers

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Why do people trade? Speculators

 Speculators are informed traders who expect a

conditional return
(Rf + Rprem + Rinfo)

 Speculators collect, analyse and produce information

that is then used to predict future price changes.

 Important difference between gamblers and

speculators...

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Why do people trade? Speculators

 Speculators differ by the information they use to

forecast future price changes:
• Informed traders
– profit from knowing fundamental values.
• Parasitic traders include order anticipators and bluffers
– act on information about other traders’ orders.
– create information to fool others.

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Harris 2003 p199 Figure 8-1
Principals

Utilitarian Profit Motivated Futile

Traders Traders Traders

Investment/Disinvestment
Speculators Dealers
Risk Sharing
Informed Parasitic
Asset Exchanges
Traders Traders
Risk Exchanging
Value-Motivated
Gambling Traders Order Anticipators Bluffers

Tax Reasons Headline Traders

Front
Runners
Information-oriented
Technical Traders
Sentiment-oriented
Technical Traders
Arbitrageurs

Squeezers

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Why do people trade? Parasitic traders

 Sentiment-oriented technical traders predict trades that

uninformed traders will decide to make.
• Trade ahead of uninformed traders.
• Profit when prediction is correct.

 Squeezers monopolise one side of a market.

• More common buying up the supply thus controlling subsequent
sale prices.
• Most common in commodity markets.

 What is the effect of trading by parasitic traders on the

market quality?

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Harris 2003 p199 Figure 8-1
Principals

Utilitarian Profit Motivated Futile

Traders Traders Traders

Investment/Disinvestment
Speculators Dealers
Risk Sharing
Informed Parasitic
Asset Exchanges
Traders Traders
Risk Exchanging
Value-Motivated
Gambling Traders Order Anticipators Bluffers

Tax Reasons Headline Traders

Front
Runners
Information-oriented
Technical Traders
Sentiment-oriented
Technical Traders
Arbitrageurs

Squeezers

22
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Informed Traders (theoretically)

 The fundamental value of a security is the expected

NPV of all future benefits and costs associated with
holding the security.
• value agreed upon if everyone knew every available piece of
information

 Informed traders trade when price differs from their

estimates of fundamental underlying value.
• Undervalued - BUY
• Overvalued to profit when the price reverts to their estimate
of the fundamental value. - SELL

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Informed Traders (practically)
 Public information vs private information
• Timing: scheduled (such as earning announcement) or unscheduled
(such as MA news)
• Content: (how significantly it would impact the stock price)
– For example, vaccine progress vs vaccine approval

Peak price = $41.69, Dec. 8

The very first person took the jab
Pfizer (ticker: PFE) https://www.bbc.com/news/uk-55227325
43
41
39
37
35
33
31
29
27
25

2020, April 23, human trials,
$32.69 to $33.09, diff = 0.4
Adj Close
2020, Dec. 2, UK the first country to
grant an approval to a COVID19 vaccine
$38.6 to $39.96, diff ~=1.4
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Informed Traders (practically)

 Whether can I trade on the information that I obtain?

• Public information or private information
• do I have any fiduciary duty to the source of information?
– If yes, NO trading.

More in Week 9

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Informed Trading Strategies

 Profit motivates informed traders and NOT a desire to

make prices more informative.
 How to max profit? Trade aggressively or slowly?
• Informed traders try to minimise their price impact to
maximise their profits.
• Trade aggressively to utilise the informational advantage
before it becomes public knowledge.
– Think about a piece of news coming out soon
– Think about a situation you are not the only informed one
• Trade slowly if they know the information will not become
public knowledge
– stealth trading

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Informed Trading Strategies

• Red/blue lines
indicate quotes
(best prices
available);
• Black dots
indicate trades;
• Trades at ask?
Trades at bid?
??
 Hasbrouck, Chp10, p93
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Styles of Informed Trading

 Value motivated traders

• Estimate fundamental values by using economic models
 Headline traders
• Estimate changes in fundamental values
 Information-oriented technical traders
• Try to forecast prices from past prices and other market data
 Arbitrageurs
• Relative differences in fundamental values using fundamental
and technical models

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What is the effect of informed trading on price?

 Trading by informed traders move price towards the

security’s fundamental value.

 Informed traders have different information, thus they

form different estimates of value.
 market price is more informative than the single estimate
from one informed trader.

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Informational efficiency and prices

 On the process that price incorporates information:

• It necessarily involves trading.
• For the informed trader to actually realize the profits, the
information must be made public.

 The degree to which market prices correctly and

quickly reflect information, informational efficiency,
depends on the trading behaviours of informed traders.
• Actions of informed traders cause the markets to have
informative prices.
• Informed traders profits from uninformed traders.
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Recall: Market efficiency

 Simple line: An efficient market is one where the

security prices reflect all available information.

 Three forms:
• Weak form
• Semi-strong form
• Strong form

Such definitions do not recognize that acquiring and

acting on information is costly.

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A market microstructure definition of market
efficiency
 Prices are efficient with respect to a set of information
if traders cannot profit from acquiring the information
and trading on it.
 At the equilibrium:

Cost of acquiring = Revenue from info

and trading on info

 What is the implication of this definition for market

places and market efficiency? ?
• Low cost market VS high cost market

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Limit Order Book Trading Game

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Overview

 Series of trading games will be conducted during the labs in

Weeks 5 - 9 (except for Week 7 - MST)
 Simulator reproduces some of the key features of securities
trading

Webpage: Lobv2.biz.uwa.edu.au
User name: first name + first 3 letters of family name + last
2 numbers of student number
e.g. Tomas Jones with student number 87654321,
TomasJon21
Password: your student number

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Week 5 Practice Week
 Prior to the lab session...
• Please read the game handout on LMS and make notes of your
questions.
• Ensure you have login information of trading simulation (previous slide).
Note that you cannot test it yet until your tutorial time.

 During the lab session...

• Trial run of games
• Make sure you are familiar with the ways orders are placed and how
trading takes place
• Consider how profit/trading costs may be calculated based on trade
history

 After the lab session…

• Complete the pre-game quiz: close on Friday in Week 5.

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Overview

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Last slide

 Lecture quiz
• LMS: Week 4 folder

 Next week
• Adverse selection in dealer markets
• Adverse selection and the bid-ask spread
• The bid-ask spread in an order-driven market

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