module 2, Ejercicios de Economía. Universidad Carlos III de Madrid (UC3M)
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module 2, Ejercicios de Economía. Universidad Carlos III de Madrid (UC3M)

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Asignatura: SISTEMAS FINANCIEROS, Profesor: , Carrera: Economía, Universidad: UC3M
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!

! 9!

Module'2.'Introduction'to'Financial'Markets'

'

Learning'Goals'

To#understand#the#workings#of#financial#markets# To#understand#the#importance#of#market#orders,#and#how#they#work.# To#understand#the#importance#of#the#law#and#the#regulations# To#interpret#any#financial#market#according#to#its#architecture.# To#understand#the#importance#of#the#different#trading#systems#and#understand# perfectly#how#they#work.# To#analyze#the#differences#between#different#forms#of#trading:#Auction# markets,#Continuous#auction#markets#(driven#by#orders)#and#PriceBdriven# markets.#

# #

Overview'

1. Introduction# 2. Types#of#market# 3. The#competition#between#markets## 4. The#new#era:#HFT#

# #

Bibliography:'

'

• Chapters#5#&#6.#Trading#and#Exchanges.#Market#Microstructure#for# Practitioners.#Larry#Harris.#Oxford#University#Press#(OUP).#

• WFE#statistics# • BME#1T17.pdf# • euronext_q1_2017_results_presentation.pdf.# • Algunos#videos:#

o Quants:#The#Alchemists#of#Wall#Street#(vpro#backlight)# ! https://www.youtube.com/watch?v=OINqYdkhOAw#

o Money#&#Speed:#Inside#the#Black#Box#(vpro#backlight)# ! https://www.youtube.com/watch?v=aq1Ln1UCoEU#

o The#Wall#Street#Code#(vpro#backlight)# ! https://www.youtube.com/watch?v=kFQJNeQDDHA##

# # #

!

! 10!

1.'Introduction'

A#financial#market#may#be#a#physical#location#or#otherwise#(electronic)#where# instruments#are#exchanged.##Today#the#vast#majority#of#markets#are#electronic.#There# are#a#number#of#reasons#for#this.#Among#the#most#important#are:#

• Price#efficiency:#many#models#of#modern#finance#involve#price#efficiency#B#in# other#words,#that#the#prices#of#instruments#incorporate#relevant,#public# information.#This#efficiency#would#be#more#difficult#of#achieve#if#the#markets# opened#every#day#for#a#few#minutes,#since#company#information#is#produced# continually#throughout#the#day# #

• Ease#and#equality#of#access:#the#fact#that#the#markets#are#electronic#facilitates# connection#by#all#operators.# #

• Volume:#this#aspect#is#perhaps#the#most#important.#The#volume#that#financial# markets#handle#nowadays#would#be#difficult#to#contemplate#without#help#from# the#computer#networks#that#take#orders#to#the#markets#and#the#computer# systems#that#carry#out#transactions.#

# The#financial#markets#can#be#classified#according#to#different#criteria.#To#be#specific#the# two#most#important:##

• According#to#the#characteristics#of#the#instruments#traded:## o Money#markets:#shortBterm#instruments#with#high#liquidity#and#low#risk#

are#traded.#The#vast#majority#of#instruments#have#a#term#no#longer#than# a#year.#

o Capital#markets:#LongBterm#instruments#with#higher#risk#are#traded.# (LongBterm#debt#market#and#Stock#market:#Fixed#Income#and#Variable# Income)#

# • According#to#the#phase#of#trading#

o Primary#Markets:#Offer#newlyBcreated#instruments#(auction#of#bills,# share#issues,#etc.)#

o Secondary#Markets:#Instruments#traded#have#already#been#created# # In#this#module#we#will#focus#on#the#organisation#of#markets#B#above#all#secondary# markets#with#securities#that#are#already#issued.##We#must#bear#in#mind#that#the# financial#markets#are#above#all#companies#that#have#shareholders,#and#whose#aim#is#to# earn#money#for#their#shareholders.# The#sources#of#income#of#a#financial#market#are#diverse#and#of#different#relative# importance#depending#on#the#market#we#look#at.#The#following#table#and#graph#shows# the#revenues#by#business#lines#of#BME# #

!

! 11!

The#structure#of#BME's#revenue#and#profits#shows#how#the#amount#of#transactions# (commission)#is#key.## #

# #

# # We#can#point#out#different#aspects.#First,#the#revenues#that#comes#as#a#result#of#stock# trading#is#the#most#important.#Second#is#the#Settlement#&#Registration.#In#this#section# we#include#the#revenues#for#the#company#derived#from#the#registration#of#the# operations#that#have#been#carried#out.#The#third#is#clearing.#Here#we#include#the# income#as#a#result#of#the#compensation#of#operations.# In#this#way#we#can#indicate#the#three#phases#of#any#operation:#Transaction,#settlement# and#compensation#and#third#register.#These#three#phases#are#carried#out#in#any# operation#of#financial#assets.# #

!

! 12!

A#good#comparison#is#to#observe#the#same#figures#for#Euronext.#1# # Given#that#operators#can#carry#out#Spanish#share#transactions#in#different#markets,#it#is# important#for#the#market#to#offer#sufficiently#high#quality#conditions#so#that#operators# carry#out#their#transactions#in#the#Spanish#market#and#not#another#market.#2# Two#good#examples#of#the#competition#between#markets#are#the#platforms:##

– Turquoise## – Bats#

# In#this#regard,#it#is#important#to#note#that#for#a#transaction#to#take#place#in#one#or# another#market,#the#investor#must#receive#the#best#execution#conditions#(BEC)#in# terms#of#the#price#of#assets#acquired#or#sold#and#transaction#costs.# # The#following#tables#show#the#distribution#of#capitalization#and#transaction#volume#of# shares#in#different#markets#of#the#world#by#May3# #

# #

!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!! 1!See!euronext_q1_2017_results_presentation.pdf.! 2!In!session!3,!we!will!develop!this!point.! 3!WFE!statistics!

Equity'('1.3'('Value'of'share'trading'(USD'millions) EOB'value'of'share'trading Exchange Year(to(date %'Total BME'Spanish'Exchanges 300196.4 0.9% Nasdaq'Nordic'Exchanges 313023.9 0.9% Australian'Securities'Exchange 340987.7 1.0% National'Stock'Exchange'of'India'Limited 380172.0 1.1% SIX'Swiss'Exchange 410417.5 1.2% TMX'Group 549801.5 1.6% Deutsche'Boerse'AG 568800.9 1.7% Hong'Kong'Exchanges'and'Clearing 657579.2 2.0% Korea'Exchange 688681.2 2.1% Euronext 766809.8 2.3% LSE'Group 956352.7 2.9% BATS'Chi(x'Europe 1019884.3 3.1% Japan'Exchange'Group'Inc. 2239069.7 6.7% Shanghai'Stock'Exchange 2894126.7 8.7% Shenzhen'Stock'Exchange 3456505.1 10.4% Nasdaq'('US 4539205.0 13.6% BATS'Global'Markets 5070017.9 15.2% NYSE 6508744.6 19.5% Total 33388593.1

!

! 13!

# # Just#point#out#how#some#of#the#markets#(BATS)#are#in#transaction#data#but#not# capitalization#since#they#have#no#listed#companies.# # Transaction'Cost'

# One#of#the#characteristics#that#defines#quality#are#the#costs#that#the#investor#must# face.#The#type#of#frictions#or#costs#are##

• Explicit#costs:#transaction#costs,#commissions,#taxes# • Execution#costs:#liquidity#

# Explicit'costs#depend#on#the#country#and#are#taxes,#commission,#etc.#All#the#costs#we# must#add#to#the#effective#volume#of#the#operation.## Three#points:#

– There#is#much#competition#among#brokers#(0.2%#on#Openbank#or#ING#Direct#or# 0.25%#BBVA.#A#esta#cantidad#debemos#añadir#las#comisiones#que#cobra#el# mercado)++++#

– Commission#rates#are#set#freely.#The#law#only#stipulates#a#maximum#(2.5%)# – The#commission#charged#to#carry#out#the#transactions#is#shared#between#the#

market,#the#entity#that#performed#the#operation#and#the#broker.# # The#following#diagram#shows#a#Reuters#screen## #

Equity'('1.1'('Domestic'market'capitalization'(USD'millions) %'Total Exchange may(17 BME'Spanish'Exchanges 882683.7 1.2% Taiwan'Stock'Exchange 988279.5 1.3% Johannesburg'Stock'Exchange 1064733.5 1.4% Australian'Securities'Exchange 1367437.4 1.8% Nasdaq'Nordic'Exchanges 1455091.7 1.9% Korea'Exchange 1548798.5 2.0% SIX'Swiss'Exchange 1641550.5 2.2% National'Stock'Exchange'of'India'Limited 1926777.3 2.5% BSE'India'Limited 1952122.1 2.6% Deutsche'Boerse'AG 2031889.1 2.7% TMX'Group 2065023.2 2.7% Shenzhen'Stock'Exchange 3161111.1 4.2% Hong'Kong'Exchanges'and'Clearing 3663331.1 4.8% LSE'Group 4047981.2 5.3% Euronext 4059354.8 5.3% Shanghai'Stock'Exchange 4361154.6 5.7% Japan'Exchange'Group'Inc. 5424014.0 7.1% Nasdaq'('US 8827942.2 11.6% NYSE 20388427.4 26.8% Total 76028806.8

!

! 14!

# This#picture#is#a#photograph#of#the#TEF#situation#on#September#16,#2011#at#4:45#pm# and#includes#the#company#information#of#the#last#year#(bottom)#and#concrete#day# (top).# # We#are#interested#in#the#part#of#the#following#table.#

# # # # # # # # #

# Here#we#can#see#supply#and#demand#every#instant# # # Bid Ask Acc Vol Vol*P Shares P P Shares Vol*P Acc Vol 93074 93074 6660 13.975 13.980 2365 33063 33063

318242 225168 16118 13.970 13.985 6200 86707 119770 470851 152610 10928 13.965 13.990 21094 295105 414875 699977 229125 16413 13.960 13.995 17487 244731 659605 802337 102360 7335 13.955 14.000 12644 177016 836621 # We#can#represent#graphically#both# #

!

! 15!

# # It#should#be#noted#that#supply#and#demand#is#available#at#this#time#and#both#define# two#important#concepts:#Depth#and#BidBAsk#Spread.# Depth#is#the#number#of#actions#available#on#each#side.# #

Bid Ask Both Acc 1 6660 2365 9025 9025 2 16118 6200 22318 31343 3 10928 21094 32022 63365 4 16413 17487 33900 97265 5 7335 12644 19979 117244

# Greater#depth#implies#greater#liquidity# BidBAsk#Spread#is#the#difference#between#the#best#buy#and#sell#price#and#shows#the# cost#of#buying#a#stock#and#immediately#selling#it.#Greater#Spread#less#liquidity.# #

Bid Ask 13.975 13.980 Spread 0.005 m 13.9775 Relative Spread 0.0358% 3.58 bps

# Let's#look#at#an#example#that#includes#explicit#and#implicit#costs# Suppose#we#buy#and#then#sell#100#shares.#Transaction#costs#are#0.6%.# #

## But#@# 11:00#

Sell#@# 11:05#

Ask# 11.50# 11.59# Bid# 11.48# 11.55#

# Explicit#and#implicit#costs#are:# EC#+#IC#=#0.6%#+#0.09%#+#0.6%#+#0.17%#=#1.46%.# The#return#is:#

# We#are#loosing#money.#

0"

100000"

200000"

300000"

400000"

500000"

600000"

700000"

800000"

900000"

13.955" 13.960" 13.965" 13.970" 13.975" 13.980" 13.985" 13.990" 13.995" 14.000"

Vol$

r = 11.55−11.50 11.50

= 0.43%

!

! 16!

2.'Types'of'market'

# In#addition#to#the#two#types#of#market#mentioned#above,#we#can#classify#them# according#to#two#additional#criteria:#those#that#are#electronic#and#continuous.# '

Not'continuous'and'Not'Electronic'

# Here#we#include#markets#that#open#for#a#short#time#every#day.#The#main#advantage#is# that#all#investors#have#the#same#information.##In#contrast,#the#main#drawback#is#that# we#only#have#a#little#time#each#day.#In#Spain,#until#1989#all#shares#on#the#Spanish#Stock# Exchange#were#traded#on#the#floor#of#the#exchange.##Since#the#creation#of#the# electronic#trading#market#the#exchange#itself#took#a#secondary#role.##The#few# companies#that#continued#to#be#quoted#under#this#system#were#not#taken#into#account# by#the#vast#majority#of#investors,#and#much#less#by#analysts.##This#way#of#doing# business#has#already#disappeared.#Now#all#companies#are#quoted#on#the#continuous# market.# # Example# Suppose#we#have#an#instrument#that#after#two#rumours#rises#19%,#and#after#a#press# conference#the#gains#are#cut#back#to#8%# This#would#not#have#happened#on#the#floor#of#the#exchange#since#all#investors#would# come#to#the#auction#with#the#same#information#

#

# # This#would#not#have#happened#if#we#had#pits#(open#outcry)#since#all#the#investors# would#arrive#at#the#auction#with#the#same#information.#Thus,#the#advantage#of#the#pits# is#the#equality#in#the#information#of#the#investors#but#the#cost#is#not#being#able#to# contract#continuously#and#evidently#this#cost#is#greater.# # NonHcontinuous'and'Electronic'

Here#we#include#electronic#auction#markets#such#as#the#stock#market#opening#and# closing#markets.#They#open#for#a#short#time#each#day#and#their#main#advantage#is#that# they#serve#to#agglutinate#the#information.#The#disadvantage#is#that#they#are#done#a# few#times#a#day.#The#auction#is#a#period#during#which#orders#can#not#be#executed#but# only#entered.#The#main#reason#for#not#being#able#to#execute#the#orders#is#to#allow#the# set#of#investors#through#their#orders#to#form#an#offer#and#a#complete#demand#with#an#

!

! 17!

equilibrium#price.#In#addition#to#obtaining#an#equilibrium#price,#the#auctions#allow#you# to#add#the#buying#and#selling#intentions#and#therefore#to#reveal#additionally#the# opinion#of#the#set#of#investors#about#an#action.#That#is,#the#preBopening#reveals# information#about#the#price#of#the#asset.#The#last#equilibrium#price#that#closes#the# auctions#is#a#price#that#is#called#a#reference#price#and#has#an#important#function# because#from#this#price#the#static#range#of#price#variation#that#will#be#used#for#the# auctions#of#volatility#of#that#day#is#generated.#Brusco#and#Tapia#show#the#learning# process#of#the#auction#in#the#Spanish#market.#4## # Continuous'and'NonHElectronic'

These#are#markets#with#trading#floors#that#open#all#day.##They#generally#have#a#parallel# electronic#market.#Some#examples#are#the#NYSE5#or#the#German#derivatives#market.# The#video#and#the#article#show#that#these#systems#are#increasingly#insignificant.# '

Continuous'and'Electronic'

Here#we#include#almost#every#share,#bond#and#derivatives#market#in#the#world.#All# work#with#LOB#although#their#transparency#can#be#greater#or#smaller.# # Continuous'markets'

The#reason#for#markets#being#continuous#is#obvious#(the#drawback#of#trading#floors# (opening/closing#times)).##But#it#is#not#so#obvious#why#continuous#markets#do#not#all# work#in#the#same#way.# In#addition#to#electronic#and#nonBelectronic,#we#can#distinguish#between:#

• PriceBdriven#markets:#markets#with#market#makers.# • OrdersBdriven#Markets:#markets#that#allow#for#placement#of#orders.#

The#basic#difference#between#these#two#types#of#market#is#that#in#PriceBdriven#markets# only#the#market#makers#can#place#limit#orders.#The#rest#can#only#place#market#orders.# On#the#other#hand,#in#OrdersBdriven#Markets:#any#investor#can#place#limit#orders#in# addition#to#market#orders.# # At#this#point,#we#need#to#consider#which#trading#system#is#better.#Theory,#experiments# and#data#analysis#have#given#a#partial#response#to#this#question.#In#practice,#markets# prefer#hybrid#markets#that#try#to#take#advantage#of#both#systems#(the#New#York#Stock# Exchange#is#a#market#of#this#type).# #

!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!! 4!Learning.pdf! 5!http://www.youtube.com/watch?v=TPUDPhpCecA! http://www.marketwatch.com/story/thisVisVtheVlastVphotoVwellVeverVrunVofVtheV nyseVtradingVfloorV2014V10V01!! !

!

! 18!

# # # 3.'Competition'between'markets'

In#recent#years,#we#have#witnessed#a#clear#increase#in#the#competition#between# financial#markets.#This#has#been#the#result#of#market#liberalization,#business# globalisation#and#the#development#of#Information#Technology## # The#competition#will#be#discussed#in#Session#3#when#we#develop#the#MiFID.#Next#we# will#analyze#the#technological#changes.# # Algorithm'Trading'and'High'Frecuency'Trading.'

#

# # # The#markets#today#are#not#inhabited#by#human#traders#but#by#computers#with# important#models#that#send#buy#and#sell#orders#automatically.# In#general#we#can#define#them#as:# Algo#Trade#Definition:#"The#use#of#computer#algorithms#to#manage#the#trading#process# (Hendershott#et#al.,#2011)"# HFT#are#similar#but#with#"holding#periods"#very#short#(milliseconds).# # The#machines#in#today's#markets#are#very#important#and#represent#(HFT#and#Algo)# more#than#75%#of#the#total#volume#of#the#markets.#

Type%of% Market% Advantage%% Drawback%% Example%%

Price<driven% Market% Maker:% constant%liquidity%for%all%securities%% Possible%collusion% Currencies,%MTS% Spain,%SENAF%

Hybrid% Markets% With%both% %% NYSE,%NASDAQ,…%%

Orders<driven% More% suppliers% and% demanders:% more% competition.%

There% is% no% guarantee% of% execution.%%

SIBE,%MEFF%%

!

!

! 19!

# There#is#considerable#controversy#over#the#positive#or#negative#effects#of#this#new# situation.# # In#addition#the#following#graphs#show#the#importance#of#this#type#of#traders.# # #

# Source:#Nanex.com## #

# Source:#Rise#of#the#Machines:#Algorithmic#Trading#in#the#Foreign#Exchange#Market.# Board#of#Governors#of#the#Federal#Reserve#System.# # #

!

! 20!

# Number#of#messages#per#minute#in#assets#classified#by#capitalization.#Q1#large,#...#Q5# small.# #

## # Source:#Hendershott,#Jones,#Menkveld.#Journal#of#Finance#2011# # Messages#per#minute#for#120#actions#in#2009#and#2005#in#the#month#of#March#(931#is# 9h#and#31#minutes#and#picks#up#messages#from#9:30#to#9:31)#

# # Two#videos#illustrate#the#possible#effects#of#the#intervention#of#this#type#of#traders#in# the#Market.# #

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! 21!

B Negative#effects# o https://www.youtube.com/watch?v=z4nCTdQlH8w#

B Positive#effects# o http://www.tradersmagazine.com/insightBbites/hftBcanBemployB

strategiesBthatBbenefitBtheBmarketB112817B1.html# # Regulatory#bodies#distinguish#between:#

B B#The#Bad#HFT# B B#The#Good#HFT#

# The'Bad'

The#advantage#over#other#market#participants#and#the#ability#to#detect#market# inefficiencies#is#the#reason#why#many#people#criticize#HFT.# The#most#common#criticisms#are:#

1. Front#Running:#HFT#companies#use#quick#access#to#orders#to#buy#stocks#before# others#and#then#sell#them#at#a#slightly#higher#price.#

#

# #

2. 2.#Quote#Stuffing:#market#manipulation#by#sending#fast#and#withdrawing#large# number#of#orders.#Due#to#the#speed#of#operations,#it#creates#a#false#impression# of#the#situation#in#the#market#that#leads#other#participants#to#execute#against# phantom#orders.#

3. 3.#Quote#Spoofing:#Another#method#for#market#manipulation#is#the#sending#and# subsequent#cancellation#of#orders#for#the#increase#/#decrease#of#prices.#When# the#market#begins#to#react,#the#new#price#allows#gaining#a#certain#benefit#to#the# HFT.#

# # #

!

! 22!

# # Hasbrouck#(2015)# #

# # Hasbrouck#(2015)# # #

!

! 23!

# #

# #

!

! 24!

# #

# # # The'good'

# HFT#Market#Makers#place#purchase#and#sale#orders#continuously.#Investment#in# infrastructure#(SW#and#HW)#and#coBlocation#allows#them#to#reduce#their#risk.#The# speed#and#the#lower#risk#allows#them#to#reduce#the#Spreads#and#therefore#the# transaction#costs#increasing#the#liquidity#of#the#values.# # #

!

! 25!

Short'Questions.'

# 1.#Are#market#makers#important?#Why?# # 2.#“Forecasters’#predictions#of#stock#prices#are#notoriously#inaccurate,#so#their# expectations#cannot#be#optimal.”#Is#this#statement#true,#false,#or#uncertain?# # 3.#Explain#in#detail#how#continuous#and#nonBcontinuous#markets#are#distinguished#by# indicating#their#advantages#and#disadvantages.# # 4.#In#their#opinion#after#the#readings#and#the#videos#the#HFT#are#good#or#bad#for#the# financial#markets.# # #

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