Financial Markets, Institutions, & the
Trading Environment (MSF 8610)
Dr. Michael Pagano, CFA
Adapted and Excerpted from Slides by:
Dr. Robert Schwartz © 2004
Baruch College
and
Wayne Wagner
President, Plexus Group
Financial Markets, Institutions, and the Trading Environment
Slide 1
Objectives
Understand:
 How markets operate from the
perspective of the users (investors, dealers,
and other intermediaries)
 How prices are set and trades made in
different market places
 That price determination and quantity
discovery are complex processes
 That prices are volatile intra-day
Financial Markets, Institutions, and the Trading Environment
Slide 2
Goal of a Trading System
Bring customer orders together to make trades:
 At reasonable cost
 In a timely fashion
 At reasonable prices
Success depends on quality of a market’s structure:
 The systems, rules and protocols that determine
how orders are handled and transformed into trades
Financial Markets, Institutions, and the Trading Environment
Slide 3
Costs
1. Definition:
• Explicit costs of trading: commissions, taxes, etc.
• Implicit costs of trading
– Transaction costs other than commissions and taxes
2. Execution Costs
• Bid-ask spread
• Market impact
• Opportunity cost
Financial Markets, Institutions, and the Trading Environment
Slide 4
Costs (cont.)
3. Effects
• Reduced portfolio returns (can result from all of these
costs)
• Inflated short-period price volatility (due to bid-ask
“bounce,” market impact, price discovery)
Financial Markets, Institutions, and the Trading Environment
Slide 5
The Iceberg of Transaction Costs
Commission
5 ¢ (17 bp)
Impact
10 ¢ (34 bp)
Delay
23 ¢ (77 bp)
Missed Trades
9 ¢ (29 bp)
Source: Plexus Group, 2003
Financial Markets, Institutions, and the Trading Environment
Slide 6
Cost Components
• Total Cost = Commission
+ Impact (intra-day)
+ Delay (inter-day)
approx. 157 bps (one-way)
 314 bps (round-trip!)
• What is the cumulative impact on a 10%
annual return over: 1, 5, and 10-year
horizons?
Financial Markets, Institutions, and the Trading Environment
Slide 7
Total Cost
Total Cost of Trading
Basis Points
250
200
150
NASDAQ
100
NYSE
50
0
Giant
Cap
Large
Cap
Mid
Cap
Small
Cap
Micro
Cap
NASDAQ
43
71
85
134
230
NYSE
43
56
81
94
138
Financial Markets, Institutions, and the Trading Environment
Slide 8
Commissions
Commission Cost
Basis Points
150
125
100
NASDAQ
75
NYSE
50
25
0
Giant Cap Large Cap Mid Cap
Small
Cap
Micro Cap
NASDAQ
16
15
22
29
50
NYSE
12
15
20
26
39
Financial Markets, Institutions, and the Trading Environment
Slide 9
Impact
Basis Points
Impact Cost
150
125
100
75
50
25
0
NASDAQ
NYSE
Giant Cap Large Cap Mid Cap Small Cap MicroCap
NASDAQ
16
28
33
37
42
NYSE
18
19
25
23
20
Financial Markets, Institutions, and the Trading Environment
Slide 10
Inter-day Delay
Delay Cost
Basis Points
150
125
100
NASDAQ
NYSE
75
50
25
0
Giant
Cap
Large
Cap
Mid Cap
Small
Cap
MicroCa
p
NASDAQ
10
27
30
67
137
NYSE
13
22
37
46
79
Financial Markets, Institutions, and the Trading Environment
Slide 11
What Drives a Market?
3 Sources of Orders
Informed
P*
Is p*>offer
or p*<bid?
Liquidity
Order Flow
Quotes,
Prices,
Volume
Technical
Trading
Is there a
trend/
pattern?
Trading Mechanism
Financial Markets, Institutions, and the Trading Environment
Slide 12
The Big Problem
Enabling Buyers and Sellers, Large and
Small, to Find Each Other
Two Dimensions
 Place
 Time
Financial Markets, Institutions, and the Trading Environment
Slide 13
Order Driven Market
Public
Seller
10:50
Public
Buyer
10:55
Places
a Buy
Limit
Order
Limit
Order
Executes
Financial Markets, Institutions, and the Trading Environment
11:00
The limit order
book brings
buyer& seller
together
Slide 14
The Limit Order Book
BIDS
Bid – Ask Spread
(10.95 - 11.10)
Air Pocket
PRICE
OFFERS
11.30
91
11.25
0
11.20
52
11.15
24
11.10
7
Air Pocket
11.05
11.00
35
10.95
70
10.90
0
10.85
20
10.80
67
10.75
39
10.70
46
10.65
Financial Markets, Institutions, and the Trading Environment
Slide 15
Dealer Intermediation
Dealer
Sells
Public
Seller
10:50
10:55
Public
Buyer
Dealer
Buys
Financial Markets, Institutions, and the Trading Environment
11:00
Dealer provision
of immediacy
brings buyer
& seller together
Slide 16
View From a Market Maker’s Desk
Dealer
Bid
Dealer
Ask
COD
26.00
CAT
26.20
DOG
26.00
COD
26.30
TUNA
25.90
DOG
26.30
CAT
24.80
TUNA
26.30
Financial Markets, Institutions, and the Trading Environment
Slide 17
Order Driven Market
Best Ask 100 shs @ $20.00
<Last sale $15
Best Bid 200 shs @ $10.00
Financial Markets, Institutions, and the Trading Environment
Slide 18
Thin Order Book
Best Public Ask 100 shs @ $20.00
<Last sale $15
< Mkt order: Sell 100
< Sold @ $10
< # @$%
*
**
Best Public Bid 200 shs @ $10.00
Financial Markets, Institutions, and the Trading Environment
Slide 19
Dealer/Specialist
“Makes” the Market
Best Public Ask 100 shs @ $20.00
Specialist Ask 100 shs @ $15.05
<Last sale $15
Specialist Bid 100 shs @ $14.95
Best Public Bid 200 shs @ $10.00
Financial Markets, Institutions, and the Trading Environment
Slide 20
Public Trades with Dealer
Best Public Ask 100 shs @ $20.00
Specialist Ask 100 shs @ $15.05
< Mkt order: Sell 100
<Last sale $15
Specialist Bid 100 shs @ $14.95
< Sold @ $14.95
< 
Best Public Bid 200 shs @ $10.00
Financial Markets, Institutions, and the Trading Environment
Slide 21
Dealer Is Long
100 Shares
Best Public Ask 100 shs @ $20.00
Specialist Ask 100 shs @ $15.05
Specialist Bid 100 shs @ $14.95 $14.90
Best Public Bid 200 shs @ $10.00
Financial Markets, Institutions, and the Trading Environment
Slide 22
A Call Auction
Public
Seller
10:50
10:55
Public
Buyer
Financial Markets, Institutions, and the Trading Environment
11:00
A meeting point
in time can bring
multiple buyers &
sellers together
Slide 23
The Electronic Call Auction
 Orders that could otherwise be matched and
executed are held for a big, multilateral clearing.
 Clearings are held at pre-determined points in
time (i.e., once an hour).
 All crossing orders are executed at a single price:
– Buy orders at that price and higher execute
– Sell orders at that price and lower execute
Financial Markets, Institutions, and the Trading Environment
Slide 24
The Batching of Customer Orders
Price
52
O
51
O
50
49
48
47
•
••
•O
•O
•
1
2
O Offer
Bid
•
O
Question
How should these limit orders
be integrated to produce a good
price?
3 4 5 6
Financial Markets, Institutions, and the Trading Environment
No. Orders
Slide 25
Cumulate The Buy Orders
• Individual buy order
Price
52
51
•• (1)
•
50
49
•
48
•
47
•
1
 Cumulated buy orders
at the price or better
•
• (1+2=3)
• (3+1=4)
• (4+1+5)
• (5+1=6)
2
3
4
5
Financial Markets, Institutions, and the Trading Environment
6
No. Orders
Slide 26
Cumulate The Sell Orders
Price
52
•
51
•
50
49
•
48
• (1)
O
O (5)
O (4)
O (3)
• O (2)
• Individual sell order
O Cumulative sell orders
47
at the price or better
1
2
3
4
Financial Markets, Institutions, and the Trading Environment
5
6
Orders
Slide 27
Match Cumulated Buy & Sell Orders
Price
52
51
P* =
CUMULATED
O
SELL ORDERS
•
•
O
50
49
48
O
O
•
•
O
47
1
2
3 4
5
Financial Markets, Institutions, and the Trading Environment
•
CUMULATED
BUY ORDERS
6
Orders
Slide 28
Price Discovery
Definition:
Finding P*, the value that best reflects the
market’s underlying demand to hold shares of an
asset.
 Locating P* is not a simple matter!
Financial Markets, Institutions, and the Trading Environment
Slide 29
Price Discovery
1. A dynamic process.
2. Accuracy is difficult to achieve.
3. Accuracy depends on Market Structure:
 Definition: the rules, systems, and
protocols that determine how orders are entered
and translated into trades.
4. Also depends on the trading behavior of
individual participants.
Financial Markets, Institutions, and the Trading Environment
Slide 30
Three Other Market Characteristics
 Immediacy
 Liquidity
 Volatility
Financial Markets, Institutions, and the Trading Environment
Slide 31
Appendix A. Key Statistical Measures
 Mean Return (via ln of Price Relative)
 Variance and S.D. of Returns
 Market Model Beta, R2, and Residual Variance.
 Variance Ratio = Var (R0,2) / [2 * Var (R0,1)]
 Volume-Weighted Average Price =
VWAP0,T = t=1,T wt * Pt
where, wt = Sharest / t=1,T Sharest
Financial Markets, Institutions, and the Trading Environment
Slide 32
•
•
•
•
Additional Measures
Quoted Spread = (Ask – Bid)
Effective Spread = 2 * (B/S) * (Pt – Quote Midpointt)
Quote Midpoint = (Ask + Bid) / 2
Realized Spread = 2 * (B/S) * (Pt – QMPt+n)
•
•
•
•
•
Tot. Trans. Cost = Delay + Impact + Missed Trades
Delay = (B/S) * (Pfirst – Porder) / Porder
Impact = (B/S) * (Plast – Pfirst) / Porder
Missed Trades =
(B/S) * (unfilled / total order) * [(Plast – Porder) /
Porder]
• Implementation Shortfall =
•
Beginning Portfolio Value – Ending Portfolio Value
Financial Markets, Institutions, and the Trading Environment
Slide 33
P* and Best Bid and Offer Quotes
$28.00
$27.00
$26.00
$25.00
$24.00
$23.00
P*
Ask
$22.00
$21.00
Bid
Day 1
Financial Markets, Institutions, and the Trading Environment
Day 2
Slide 34
Market Structures
Financial Markets, Institutions, and the Trading Environment
Slide 35
Topic 6
Liquidity
Financial Markets, Institutions, and the Trading Environment
Slide 36
Liquidity
CAPM, the frictionless environment
2 dimensions: risk and return
Liquidity is perfect and a stock can be traded
immediately at its equilibrium value (P*)
Actual markets
3 dimensions: risk, return, and liquidity
Financial Markets, Institutions, and the Trading Environment
Slide 37
Liquidity: What is it?
Difficult to define & measure but –
 You know when it’s not there
A quick definition:
 Lots of orders on the book
 Lots of order flow
Without sufficient liquidity, a
market will not function
Financial Markets, Institutions, and the Trading Environment
Slide 38
What Do the Following Have in
Common?
Without Gas, Neither Will Run
Financial Markets, Institutions, and the Trading Environment
Slide 39
Order Flow is Gas For a Market
Order Flow = Liquidity
An excellent system will not operate
if it does not receive
Critical Mass Order Flow
“Order flow attracts order flow”
Financial Markets, Institutions, and the Trading Environment
Slide 40
Illiquidity
A Problem For All Markets
A Bigger Problem for Small Cap Stocks
Evidence of Illiquidity
High Intra-Day Volatility
High First ½ Hour volatility
Financial Markets, Institutions, and the Trading Environment
Slide 41
Liquidity
Attributes of a liquid asset
 Breadth: orders on the book exist at an array of
prices in the close neighborhood above and below the
price at which shares are currently trading.
 Depth: orders are of large size.
 Resiliency: price changes due to temporary order
imbalances quickly attract new orders to the market,
thereby restoring reasonable share values.
 Frequent trading.
Financial Markets, Institutions, and the Trading Environment
Slide 42
Liquidity
Attributes of an illiquid asset
 Little breadth, depth, or resiliency
 Accentuated short-period price volatility
Financial Markets, Institutions, and the Trading Environment
Slide 43
2H
5i
%
g
h
e
r
C
o
s
t
O
f
T
r
a
d
i
n
g
Hierarchy of Liquidity
Size of Trade
Percent
Of daily
volume
100%
Revealed
Flow
Hidden
For hire
Last resort
Cost
Financial Markets, Institutions, and the Trading Environment
Slide 44
Level Of
Transaction
Nature of
Liquidity Provider
Type of
Liquidity
Revealed
Publicly
pre-committed
Natural
Traffic Cop
Flow
Will decide to trade
in a short timeframe
Natural
Traffic Cop
Hidden
Privately
Pre-committed
Natural
Information-central
Secret keeper
For hire
Stand-by
commitment at a
price
Situational
(Liquidity seller)
Information-central
bush beater
Last resort
Value investor
Natural
(Contrarian)
Traffic Cop
Financial Markets, Institutions, and the Trading Environment
Role of
Market Maker
Slide 45
Building Liquidity
1. Attract Investor Attention
Stocks are not bought
They are sold
Financial Markets, Institutions, and the Trading Environment
Slide 46
Building Liquidity
2. Develop A Good Environment
 Strong Regulation of Abuses of Power and
Position
From Trading Surveillance to Corporate
Governance
 Clearance and Settlement
 Control Volatility
 Nurture an Equity Culture
Financial Markets, Institutions, and the Trading Environment
Slide 47
Building Liquidity
3. Attract Limit Orders
 Commission Structure
 Rules of Order Execution
 Strict Time and Price Priorities
 Tick Size
Financial Markets, Institutions, and the Trading Environment
Slide 48
Building Liquidity
4. Role of Intermediaries
 Natural vs Supplemental Liquidity
 Dealer Capital
 Animate the Market
Financial Markets, Institutions, and the Trading Environment
Slide 49
Building Liquidity
5. Involve the Listed Companies
 Natural vs Supplemental Liquidity
Financial Markets, Institutions, and the Trading Environment
Slide 50
Building Liquidity
6. Include Call Auction Trading
Financial Markets, Institutions, and the Trading Environment
Slide 51
Call Auction Trading
Bunch orders together for:
 Simultaneous Execution
 In a Multilateral Trade
 At a Single Price
 At a Pre-Determined Point in Time
A POWERFUL TRADING VEHICLE
Financial Markets, Institutions, and the Trading Environment
Slide 52
Liquidity & Random Walk
Positive Intertemporal Correlation
 Sequential information arrival
 The limit order book
 Market maker intervention
 Inaccurate price discovery
Negative Intertemporal Correlation
 Bid-ask spread
 Market impact effects
 Inaccurate price discovery
Serial Cross-Correlation
Financial Markets, Institutions, and the Trading Environment
Slide 53
Market Structure Issues
 Fragmentation
 Free riding
 Systemic problems
 Price discovery
 Hybrid market structures
 Intermediary and market center profitability
 Handling institutional order flow
 Proper identification of customer
Financial Markets, Institutions, and the Trading Environment
Slide 54
INTRADAY VOLATILITY
NYSE
October - December 1999
Half-Hour Volatility
1.60%
The First 1/2 Hour
1.20%
0.80%
0.40%
Financial Markets, Institutions, and the Trading Environment
3:
30
-4
:0
0
3:
00
-3
:3
0
2:
30
-3
:0
0
2:
00
-2
:3
0
1:
30
-2
:0
0
1:
00
-1
:3
0
12
:3
01:
00
30
12
:0
012
:
00
11
:3
012
:
30
11
:0
011
:
30
00
10
:3
011
:
10
:0
010
:
9:
30
-1
0:
00
0.00%
Slide 55
Making the Trade
(based on Navarro chapters)
Financial Markets, Institutions, and the Trading Environment
Slide 56
The Stock Market and Business Cycles
 Stock Market is a leading economic indicator
 Different Sectors shine at various points
during the business cycle.
 Early / Middle / Late Bull Markets:
Transportation / Capital Goods / Commodities
 Early / Middle / Late Bear Markets:
Consumer Staples / Utilities / Cons. Cyclicals
Financial Markets, Institutions, and the Trading Environment
Slide 57
The Interest Rate Cycle & Yield Curve
 Yield Curve can be a Leading indicator of
both the Stock Market and Economy.
 Federal Reserve sets short-term rates but…
 Long-term rates set by investor expectations
of economic growth and inflation.
 Bonds and Money Market instruments can
be competitors to Stocks.
Normal / Steep / Inverted / Flat Yield Curves:
Middle Bull / New Bull / Bearish / Mixed
Financial Markets, Institutions, and the Trading Environment
Slide 58
Managing Risk
 3 Key Risks: Market, Sector, Company.
 Compute Reward-to-Risk Ratio for your
trades / stocks:
Ad hoc Rule of Thumb (3:1), Sharpe Ratio,
Alpha, Beta.
 Diversification is very important (e.g., “no
more than 20% in one sector”).
 “Never bet the farm!”
 “When in doubt, go flat.”
Financial Markets, Institutions, and the Trading Environment
Slide 59
Managing Trade Execution
 Market vs. Limit Orders
 Trading Range vs. Trending Markets
 Intelligent Stop Loss orders:
 Set “loose stops”
 Avoid round numbers & technical nodes
 Use “trailing stops” to lock in gains
 “Never turn a winner into a loser”
 “Never average down a loss”
 “Never churn your own portfolio”
Financial Markets, Institutions, and the Trading Environment
Slide 60
Topic 8
Institutional Order Flow
Financial Markets, Institutions, and the Trading Environment
Slide 61
The Eye of the Storm
 The institutions are huge
 Markets are structured for retail order flow
 How can the big guys get the liquidity they need?
Big Pegs and Tiny Holes
 Dealer capital
 Place limit orders
 Trade negotiation
 Not held (NH) orders
 Slice, dice and shred
Financial Markets, Institutions, and the Trading Environment
Slide 62
Price and Quantity Discovery
 Institutions avoid active participation in
price discovery
 Institutional and retail order flow should
be integrated
 Latent demand (invisible quantity)
Financial Markets, Institutions, and the Trading Environment
Slide 63
Remarks from John Phinney*
• To a retail investor, the stock exchanges look
like a vending machine!
• This is not the case for the institutional
trader. As we know, the “peg” of institutional
trading interest is much larger than the “hole”
size of the exchange process.
* Remarks made at Baruch Conference, Coping With
Institutional Order Flow, NYC, April 29, 2003
Financial Markets, Institutions, and the Trading Environment
Slide 64
Remarks from John Phinney (cont.)
• The “meat grinder” appears clearly in all of
our data sampling.
• Trading costs seem to be much more related to
endogenous market factors, structure, and
process, than to exogenous factors derived from
investor behavior.
Financial Markets, Institutions, and the Trading Environment
Slide 65
Phinney’s Meat Grinder Example
1.8 Million Buy Order for Oracle,
August 15, 2002
Executions
Number:
Average size:
Largest :
Smallest:
1000 shares or less
100 shares or less:
Time to complete:
1,000+
1,700 shares
64,000 shares
13 shares
61% of execs
17% of execs
51 minutes
Financial Markets, Institutions, and the Trading Environment
Slide 66
Phinney’s Conclusion
It was a DFT
It required a 1,000-to-1 reduction of the
manager’s intent (and a significant amount
of technology) to get trade pieces small
enough to be digestible by the market.
Financial Markets, Institutions, and the Trading Environment
Slide 67
Best Execution
 1975 Security Acts Amendments
 Retail vs. institutional order flow
 Execution price vs
 Speed
 Certainty
 Anonymity
 Control
 Etc.
 An order is multi-dimensional.
Financial Markets, Institutions, and the Trading Environment
Slide 68
What is Best Execution?
•
A snapshot assessment for a single, no brainer order?
– What about orders that are sliced & diced?
– Order that are market timed?
• Beating a performance benchmark?
• Quality of procedures followed?
• None of the above?
• Best Execution is better thought of as a process.
Financial Markets, Institutions, and the Trading Environment
Slide 69
Is it “Best” Execution That is Needed?
Not Really
Institutional investors want to trade at
Validated Prices
Consider a PM
• Who is willing to pay up to $45 if…
$45 is the price at which shares are trading
• Who pays $38 and, in a matter of minutes or
hours, see trades at $36
Financial Markets, Institutions, and the Trading Environment
Slide 70
A Validated Price
 Crossing Networks
 VWAP Trading
Others having traded at the price
validates the price
No presumption that
Crossing Benchmarks or VWAP are
well-discovered Prices
Financial Markets, Institutions, and the Trading Environment
Slide 71
Impediments to Best Execution
•
•
•
•
Soft dollar commitments
Use of an erroneous benchmark
Excessive pressure to trade quickly
Imperfect market structure
Financial Markets, Institutions, and the Trading Environment
Slide 72
Heart of the Problem
Soft Dollars
Outsourcing research, computer
systems, and other support services
to sell-side with client assets used
as payments => Agency Problem!
(The costs are hidden)
Commission Bundling
Financial Markets, Institutions, and the Trading Environment
Slide 73
Why?
Fund Performance is hard to assess
(Why make it easy?)
General lack of systematic positive correlation
between past performance and current returns
but…
explicit payments for research, etc. would be…
explicit
Financial Markets, Institutions, and the Trading Environment
Slide 74
Consequences
 Higher trading costs
 Induced demand for immediacy
 Lower investment performance
Financial Markets, Institutions, and the Trading Environment
Slide 75