The dealer acts as an auctioneer in some market structures, thereby providing
order and fairness in the operations of the market.
The role of a market maker in a call market structure is that of an auctioneer. The
market maker does not take a position in the traded security, as a dealer does in a
Dealers also have to be compensated for bearing risk. A dealers position may
involved carrying inventory of a security (a long position) or selling a security that
is not in inventory (a short position).
Three types of risks are associated with maintaining a long or short position in a
given security. First, the uncertainty about the future price of the security
presents a substantial risk. A dealer who takes a long position in the security is
concerned that the prices will decline in the future; a dealer who is in a short
position I concerned that the price will rise.
The second type of risk concerns the expected time it will take the dealer to
unwind a position and its position and its uncertainty, which, in turn, depends
primarily on the rate at which buy and sell orders for the security reach the
market. Finally, although a dealer may be able to access better information about
order flows than the general public, in some trades the dealer takes the risk of
trading with someone in possession of better information.
- The term efficient, used in several context, describe the operating
characteristics of a capital market. A distinction, however, can be made
between an operationally (or internally) efficient market and a pricing (or
externally) efficient capital market.
- In an operationally efficient market, inventors can obtain transaction
services as cheaply as possible, given the costs associated with furnishing
- Refers to a market where prices at all times fully reflect all available
information that is relevant to the valuation of securities.
Price formation process defined the “relevant” information set that prices should
reflect. Fama classified the pricing efficiency of a market into three forms: weak,
semi-strong, and strong.
Weak efficiency- means that the price of the security reflects the past price and
trading history of the security.
Semi-strong efficiency- means that the price of the security fully reflects all
public information, which includes but is not limited to historical price and trading
Strong efficiency- exist in a market when the price of a security reflects all
information, whether or not it is publicly available.
A price efficient market carries certain implications for the investment strategy
investors may wish the purpose.
- In an investment era where one half of one percentage point can make a
difference when a money manager is compared against a performance
benchmark, an important aspect of the investment process is the cost of
implementing an investment strategy. Transaction costs are more than
merely brokerage commissions-they consist of commissions, fees, execution
cost, and opportunity costs.
Commissions- are the fees paid to brokers to trade securities. In may 1975
commissions became fully negotiable and have declined dramatically since then.
Included in the category of fees are custodial fees and transfer fees.
Custodial fees are the fees charged by an institution that holds securities in safe
keeping for an investors.
Execution costs represent the difference between the execution price of a
security and the price that would have existed in the absence of trade. Execution
costs can be further decomposed into market (or prices) impact and market timing
Market impact costs- is the result of the bid-ask spread and a price concession
extracted by dealers to mitigate their risk that an investors demand for liquidity
is information motivated.
Market timing costs- arises when an adverse price movement of the security during
the time of the transaction can be attributed in part to other activity in the
security and is not the result of a particular transaction.
Information-motivated trading occurs when the investors believe they possess
pertinent information not currently reflected in the security’s prices.
Informationless trades results from either a reallocation of wealth or
implementation of an investing strategy that utilizes only existing information.
Opportunity costs may arise when a desired trade fails to be executed. This
components of costs represents the difference in performance between an
investors desired investment and the same investors actual investment after
adjusting for execution costs, commissions, and fees.