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Chapter 5Secondary Market Making

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A. Secondary Market Making – Dealer/Broker Activity

1. Give financial claims greater liquidity Investors Issuers Investment Bankers

2. Stock return, Liquidity and Order imbalance Order imbalance theory

Buyer-initiated order Seller-initiated order

Information asymmetry in return-volume relation Speculative trade Hedge trade

3. Dealing vs. Brokering Bid-ask spread commission

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B. Dealers1. Instruments

Traders in dealer markets – swaps, mortgage-backed products, etc.

Traders in exchanges – futures Traders in dealer markets and exchange markets

2. Functions Provide a quote Size a quote

3. Reasons to participate Take profit – bid-ask spread

Price vs. InventoryMarket Microstructure

Develop and maintain good pricing skills Secondary market making supports primary market

making

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4. Managing dealers risks Identify the risks

Systematic risk Unsystematic risk Interest rate risk Credit risk Call risk Prepayment risk Purchasing power risk Tax rate risk

Quantify the risks Natural hedge Value at Risk (VaR)

Managing the risks Short or long position Building blocks

5. Inventory financing Repo market

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C. Brokers

1. Functions Fill orders market order vs. limit order Floor trading order book

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Other services Monitor margin accounts

Initial margin vs. maintenance margin Margin call

Offer investment management service Process dividends and interest coupon

Assist in structuring portfolios Real estate Stock and bonds Mutual funds Life insurance policy Retirement account

Provide research and recommendation

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2. Possible abuses Bucket shops Securities firms that take customer orders but do

not immediately execute them. Boiler rooms Firms that use high-pressure sales tactics to sell securities. Churning Excessive trading of a customer’s account to earn commission, especially in discretionary trading

account. Front running Trading ahead of a customer Poor fills Hold and signal market orders

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D. Speculators

1. Speculation and manipulation Speculation： to take a position in anticipation

of a change in price level. Manipulation： to use personal power to affect

prices to produce personal gains.

2. Speculative methods Fundamental analysis Technical analysis

3. Trading methods Absolute value trading Relative value trading Rating forecasting Complex forecasts

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E. Arbitrager Arbitrage is defined as the simultaneous taking of

positions in two or more markets in order to exploit pricing

aberrations among them.1. Spatial arbitrage

Geographic arbitrage Temporal arbitrage： program trading cash price vs. forward price Temporal arbitrage： the cash-and-carry synthetic A cash-and-carry transaction involves the purchase of an instrument and the simultaneous sale of a future contract in order to create a

synthetic short-term instrument and to earn low-risk short-term rates.