P.V. VISWANATH
FOR A FIRST COURSE IN INVESTMENTS
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 What are the different asset classes?
 Why is it important to separate them by asset class?
 What distinguishes the various asset classes?
 Why are indices important and how are they
constructed?
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 Target audience
 Public Offering
 Private Placement
 Degree of Familiarity with Security
 Initial Public Offering
 Seasoned Equity Offerings
 Novelty of the Security
 Primary Markets
 Secondary Markets
 Why do we make these kinds of distinctions? Each
typology says something about the issues involved.
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 Direct Search Markets (New Market in non-listed
securities; WSJ/NY Times article)
 Brokered Markets
 Dealer Markets
 Auction Markets
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Order-Driven Market
Bid-Driven Market
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 Market Orders
 Price-Contingent Orders
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 Dealer Markets
 ECNs
 Specialist Markets – obligation to maintain a fair
and orderly market
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 Broker Commissions
 Bid-Ask Spread (Implicit cost)
 Liquidity Cost
 Quality of Execution (if there’s a wait, then a worse
price may be obtained) (Effective Bid-Ask Spread)
 Margin Cost
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 The bid-ask spread is the price that impatient traders
pay for immediacy. The spread is the compensation
that dealers and limit order traders receive for
offering immediacy.
 Traders consider the spread when deciding whether
to submit limit orders or market orders. When the
spread is wide, immediacy is expensive, market order
executions are costly, and limit order submission
strategies are attractive.
 The spread is also the most important factor that
dealers consider when deciding whether or not to
offer liquidity in a market. If the spread is too
narrow, dealing may not be profitable.
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 Transaction cost spread component – that part of the
bid/ask spread that compensates dealers for their normal
costs of doing business. These include financing costs for
their inventories, wages for staff, exchange membership
dues, expenditures for telecommunications, research,
trading system development, clearing and settlement,
accounting, office space, utilities, etc.
 The adverse selection spread component is the part of
the bid/ask spread that compensates dealers for the
losses they suffer when trading with well-informed
traders. This component allows dealers to earn from
uninformed traders what they lose to informed traders.
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 The dealer first uses all information currently available to
her to estimate the asset value. This estimate V0 is the
basis for her bid and ask quotes.
 Using this basis, she estimates the asset value, assuming
that the next trader is a buyer (V0B) or a seller (V0S). For
example, if the next trader is a buyer, then the chances
are (e.g. if the buyer is informed), that the true value V0
is higher. Taking the prob of an informed buyer, the
dealer comes up with V0B. And similarly for V0S .
 She obtains her ask price by adding half of the
transaction cost spread component to her value estimate
for a buyer. She likewise obtains her bid price by
subtracting half of the transaction cost spared
component from her value estimate for a seller.
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Ask0
Transaction Cost
component
V0B
Adverse
selection
component
V0
V0S
Bid0
Transaction Cost
component
Components of the Total Spread
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 When the next trader arrives, the dealer learns whether she wants to
buy or sell. If the dealer learns nothing more about the trader or
about values, other than that the new trader is a buyer or a seller,
then the dealer’s new unconditional value estimate will be the
appropriate previous conditional value estimate. The bid and the
ask will both rise by half of the adverse selection component.
Ask1
Last trader was a
buyer
If the next trader
is a buyer
V1B
Ask0
V1S
V0
Bid1
If the next trader
is a seller
Bid0
Quotation Adjustments after a buyer arrives
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 The bid-ask spread will be non-zero even in order driven
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markets.
Trading costs/commissions are likely to be higher for limit
traders than for market traders because they are more
demanding of the exchange’s and the broker’s resources.
Suppose commissions for limit orders are l per round trip and
m for market orders.
Then assuming that considering that limit traders make the
bid-ask spread and market traders pay it, and considering that
any trader can either put in a limit or market order and so, in
equilibrium, would be indifferent between the two, it must be
the case that the net costs for the two types of trades are equal.
Hence l-s = s+m, or s = (l-m)/2
That is, the bid-ask spread (i.e. the difference between the
highest limit buy price and the lowest limit sell price – the price
at which limit traders are willing to sell) will be non-zero.
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 However, limit orders are not guaranteed to execute.
 Also, they provide liquidity and can be picked off by
better informed traders, as discussed above.
 Hence the bid-ask spread spread will be greater,
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the greater the spread between limit order commissions and
market order commissions,
the greater the cost of canceling and resubmitting limit orders
the more volatile underlying true asset values are (the greater
the volatility of true values, the greater the value of the timing
option granted by limit traders)
the greater the information asymmetry.
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 Securities Act of 1933
 Securities Exchange Act of 1934 – establishes the
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SEC
Commodity Futures Trading Commission
Securities Investor Protection Act of 1970
FINRA (Financial Industry Regulatory Authority) –
non-governmental self-regulation body
Sarbanes-Oxley Act
Insider Trading regulations – recent investigations
of the SEC