FINA 4103: Financial Markets Trading and Structure

Homework Assignment 1
Solution

Fall 2023

Note

• Unless otherwise noted, we follow the definitions introduced in the class. Also, we
apply the following assumptions.

– Assume that the tick size (the grid space) of the price is one dollar ($1) rather
than one cent (¢1) for simplicity.
– Assume that all standing limit orders on the LOB are plain limit orders with no
additional instructions. No hidden orders exist.
– Assume that no fees are charged for trade execution and order routing.

• For questions involving calculations, please choose the closest answer.

• Each (sub)question has 2pts, and the total score is 30pts.

Questions

1. Which one of the following statements provides the most appropriate explanation re-
garding OTC markets?

(a) In typical OTC markets, only dealer banks are trading assets with each other.
(b) In typical OTC markets, information about trades and quotes are not displayed
and held confidential among trading parties.
(c) As OTC markets are constructed by decentralized networks, traders face less se-
vere search and matching frictions compared to a centralized exchange for stocks.

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 (d) OTC markets typically trade non-standardized illiquid assets, but some major
assets, such as the US government bonds and foreign exchanges are also traded
OTC.
(e) None of the answers are correct

2. The Central Counterparty in OTC markets

(a) aims at mitigating the search and matching frictions.

(b) aims at making OTC markets more transparent.
(c) aims at mitigating the contagious effect of default by one party on the entire
network.
(d) covers settlement of almost all assets traded OTC.
(e) None of the answers are correct.

3. Which one of the following statements is correct regarding comparison between OTC
and centralized limit-order books (CLOB)? [(a) typically information about counter-
party network is not transparent in OTC market. And we cannot compare with LOB,
as LOB market is centralized and does not have ambiguous trader network. (c) OTC is
open to traders, if a small trader like you request a quote to your dealer, you are a part
of OTC. LOB is not open to you and you need to go through a licensed broker/dealer
who has direct access]

(a) Compared to a CLOB for equities, information about counterparties and the
further network is clear in OTC trading.
(b) The pricing mechanism of OTC markets is as standardized as the pricing by the
CLOB algorithm.
(c) All types of investors have direct access to an equity exchange with a CLOB,
while only registered brokers/dealers can directly trade in OTC markets.
(d) Via higher liquidity, CLOB provide more flexible trading terms than OTC trading.
(e) None of the answers are correct.

4. Which one of the following statements provides the most appropriate explanation about
trading mechanisms?

(a) The LOB algorithm is typically considered as a single auction mechanism.

(b) The Walrasian auction mechanism is always an efficient way to determine a unique
market clearing price.

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 (c) Some stock exchanges end their opening and closing auctions at random timing
to mitigate the risk of information leakage.
(d) Although circuit breakers reduce market volatility during the trade suspension,
they may contribute to making markets more volatile for the entire trading session.
(e) None of the answers are correct.

5. Which one of the following statements is correct in comparing the two largest ex-
changes, NYSE and NASDAQ?

(a) Historically, NASDAQ is characterized as a specialists market.

(b) NYSE has a trading floor with human intermediaries and does not use the elec-
tronic limit-order trading system.
(c) Human intermediaries at NYSE do not trade on their own account regardless of
the market condition.
(d) Registered dealers on NASDAQ actively quote and trade on their own accounts.
(e) None of the answers are correct.

6. Which one of the following statements is correct in comparing continuous and discrete
markets?

(a) In the continuous LOB market, if two limit orders offer the same price, the LOB
algorithm randomly determines their execution priority.
(b) Even in the continuous markets, the actual trading happens in a discrete manner.
(c) Frequent batch auctions are proposed to mitigate the computational burden of
continuous LOBs.
(d) We do not observe discrete trading sessions on typical centralized stock exchanges.
(e) None of the answers are correct.

7. Consider the “Initial LOB” in Figure 1. You placed a stop limit buy order for 20 shares
with bid price $118 and stop price $117. Subsequently, a market buy order for 100
shares arrived at the market and traded against standing limit orders. Which one of
the LOBs (a)-(d) in Figure 1 appropriately describes the post-trade state?

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 Figure 1: Figure for Q7

[The market buy will trade and walk up to price $117, consuming 100 shares. That
means the price after the market buy is $117, and remaining limit sells are 70 shares
at $117 and those at higher prices. Then, the stop limit buy at $118 is activated,
which trades against 20 shares of limit sell remaining at at $117. So, we have 50 shares
remaining at $117.]

(a) (a)
(b) (b)
(c) (c)
(d) (d)
(e) None of the answers are correct

8. In the same situation as Question 7, which one of the following LOBs (a)-(d) in Figure
2 realizes if your stop limit buy order has both the bid price and the stop price at
$116?

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 Figure 2: Figure for Q8

[The same result for the first market buy. Although the limit buy is activated, there is
no sell limit order standing at $116, as the first market buy has already consumed it.
So, the activated limit buy for 20 shares at $116 should stand on the LOB. No answers
show this buy limit order]

(a) (a)
(b) (b)
(c) (c)
(d) (d)
(e) None of the answers are correct

9. Consider the “Initial LOB” in Figure 3. You placed a limit buy order for 100 shares at
bid price $116 to your broker with the All-or-None (AON) instruction. A few minutes
later, the LOB receives a limit sell order for 120 shares at ask price $115. Which one
of the LOBs (a)-(d) in Figure 3 represents the post-trade state of the LOB?

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 Figure 3: Figure for Q9

[The relevant orders are (1) the standing limit buy of 100 shares at $115, (2) your
AON, and (3) the incoming limit sell of 120 shares at $115. When you send (2) to
your broker, there is no sufficient sell order at your limit price. Following the AON
instruction, your broker does not place it on the LOB and holds it. Then (3) arrives at
the LOB. At this moment, (3) will be matched with (1), consume all shares of (1), and
the remaining 20 shares of limit sell will stay at $115 on the LOB. The LOB has 20
shares of sell limit at $115 and 50 shares of sell limit at $116, but they are not enough
to complete AON. So the broker will do nothing. The key here is that the AON is the
instruction that a customer (you) specifies to express her broker her intensity to trade
a certain quantity. The broker does not place it on the LOB until the order can be
executed all at once.]

(a) (a)
(b) (b)
(c) (c)
(d) (d)
(e) None of the answers are correct.

10. Consider the “Initial LOB” in Figure 4, when the National Best Ask is $115. You
placed a Primary-peg sell limit order for 100 shares.

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 Figure 4: Figure for Q10

(a) Which one of the LOBs (a)-(d) appropriately describes the LOB screen that gen-
eral traders observe? [Peg orders are not displayed]
i. (a)
ii. (b)
iii. (c)
iv. (d)
v. None of the answers are correct
(b) Suppose that an IOC limit buy order for 100 shares with bid price $116 arrives
at your exchange. After this order is executed, the last execution price should be
[(b) and (c): see the example in the lecture note]
i. $116
ii. $115
iii. $114
iv. $113
v. None of the answers are correct
(c) Suppose that an IOC limit buy order for 100 shares with bid price $115 arrives
at your exchange. After this order is executed, the last execution price should be
i. $116
ii. $115

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 iii. $114
iv. $113
v. None of the answers are correct

11. Consider an economy in which a single risky asset is traded between you and your
friend. The true value of the asset is either V = $1 (high) or V = −$1 (low) with the
same probability, but at the trading stage the true value is not observable per se. In
the end of the period, true information about V is publicly revealed and the asset is
liquidated (so asset holders receive $V ). Assume the following roles:

• You serve as a market maker and are obligated to provide limit sell and buy orders
for one unit each at ask price A and bid price B.
• Your friend seeks to maximize her profits by using a market order.

Assume that all traders can trade only one unit of the asset (e.g., due to capacity
constraints), and the bid and ask prices must be such that 0 ≤ A ≤ 1 and −1 ≤ B ≤ 0
(i.e., limit orders have been already placed and you cannot control these prices). As a
reference, the LOB looks like the figure below.

Sell (Ask) Buy (Bid)

0 1
1 A
0
B 1
−1 0

(a) Assume that your friend is an insider and knows that V = $1 in trading t = 1.
Which of the following describes her optimal strategy and resulting profits?
i. Place a market buy order and receive 1 − B
ii. Place a market sell order and receive 1 − B
iii. Place a market buy order and receive 1 − A
iv. Place a market sell order and receive 1 − A
v. None of the answers are correct.
(b) If you get to know that V = 1 before your friend trades, which one of the following
strategies leads to your maximum profit? [(i) and (ii) generate zero profit. (iii)
Your friend will buy one unit of the asset at the proposed price by you. So you

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 receive payment of A but give up one unit of asset whose value is 1. So the profit
is A − 1 < 0 and negative.]
i. Cancel both limit orders.
ii. Cancel both limit orders and post new limit orders at modified prices A0 =
B 0 = $1.
iii. Keep the standing limit orders as they are.
iv. (i) and (ii) lead to the same result
v. (i) and (iii) lead to the same result
vi. (ii) and (iii) lead to the same result
(c) Before the trade happens, you and your friend get to know that V = $1 and
take the optimal behavior described in questions above. By default, these two
messages (orders) have the same speed and win the race to execution against
each other with probability 0.5. However, your friend has the option to use a
higher-speed technology to increase the winning probability to 0.8 by paying cost
$c. Your friend should use this technology if [Without using the new tech, the
expected profit of your friend is 0.5 × (1 − A), as she/he can buy $1 worth of asset
at price A < 1 with prob 0.5. By using the tech, the profit becomes 0.8(1 − A) − c
incorporating the cost of technology adoption. So, she wants to use it if and only
if 0.3(1 − A) > c. This inequality holds only with (iv).]
i. A = $0.95 and c = $0.2
ii. A = $0.85 and c = $0.1
iii. A = $0.75 and c = $0.2
iv. A = $0.65 and c = $0.1
v. Should always use the technology regardless of A and c.