INVESTMENT MANAGEMENT
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Prof. Abhijeet Chandra
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Vinod Gupta School of Management
Indian Institute of Technology Kharagpur
N Lecture 04: Ecology of Financial Markets
• Role of demand and supply in trading of financial securities
• Mechanism for trading of financial securities
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• Law of demand and supply
• Security trading
• Price discovery
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• Trading mechanism
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The Ecology of Financial Markets: Based on Demand and Supply
Hey, I want to buy a share
of a company called ‘how Sure. It’s $1.50 a piece.
to get rich quickly. How
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much is it?
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Buyer
N Seller
Adapted from Bauchaud et al. (2018); Original source: “6” by Alexandre Laumonier
The Ecology of Financial Markets: Based on Demand and Supply
It’s $1.60 a piece.
OK. I will take it.
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Buyer
N Seller
Adapted from Bauchaud et al. (2018); Original source: “6” by Alexandre Laumonier
The Ecology of Financial Markets: Based on Demand and Supply
That was before I knew
What? You just said you wanted it.
$1.50.
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Buyer
N Seller
Adapted from Bauchaud et al. (2018); Original source: “6” by Alexandre Laumonier
The Ecology of Financial Markets: Based on Demand and Supply
It’s my stuff. I can do
You cannot do that! whatever I want.
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Buyer
N Seller
Adapted from Bauchaud et al. (2018); Original source: “6” by Alexandre Laumonier
The Ecology of Financial Markets: Based on Demand and Supply
But I need a hundred of Ah! A hundred? It’s $1.70
those! Care to change apiece.
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your mind?
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Buyer
N Seller
Adapted from Bauchaud et al. (2018); Original source: “6” by Alexandre Laumonier
The Ecology of Financial Markets: Based on Demand and Supply
It’s the law of supply and
demand, buddy. You want
This is insane! it or not?
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Buyer
N Seller
Adapted from Bauchaud et al. (2018); Original source: “6” by Alexandre Laumonier
The Ecology of Financial Markets
Markets: Based on Demand and Supply
What’s a market?
• A place where buyers meet sellers, nowadays virtually and anonymously,
to perform trades, and where prices adapt to supply and demand.
• At the heart of all financial markets lies a common ingredient: people!
These people act in their best interest (supposedly), given their
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environment and the set of rules that govern it.
• Fundamental tension: buyers want to buy low and sellers want to sell high.
Given these opposing objectives, how do market participants ever agree
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on a price at which to trade?
• If a seller is allowed to increase the price whenever a buyer
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declared an interest to buy, then the price could reach a level so
high that the buy might not want to buy at all, and vice versa.
• Financial markets provide mechanism to facilitate such trades.
The Ecology of Financial Markets: Based on Demand and Supply
Functions performed by any market:
• To disseminate information, thus promoting price discovery. Market
should enable participants who want to buy or sell to find out prices at
which trades can be agreed.
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• To provide a trading mechanism, thus facilitating the making of
agreements b/w buyers and sellers. Those who wish to sell can
communicate with those wishing to buy.
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• To enable the execution of agreements between buyers and
sellers at agreed price (aka settlement function). Market
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should confirm the transaction, clear the trade, and settle the
accounts.
The Ecology of Financial Markets: Based on Demand and Supply
A generic demand-supply function looks like this:
Price Supply
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p*
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Q*
Demand
Quantity
Market equilibrium for a single asset
The Ecology of Financial Markets: Trading Mechanism
Market participants can be classified into the following broad groups:
• Public investors (who ultimately own the assets), Brokers (who act as agents
for public investors for a fee), and Dealers (who do trade on their own).
An individual wishing to buy/sell a security must indicate the following:
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• The name of the issuer of the security and the type of security that the
investor wishes to trade (e.g., Tata Motor’s equity share or a 10y GoI bond)
• Whether the order is a buy or sell of the specified security;
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• Order size, i.e., quantity/volume of the security;
• The type of order that is being placed and for some type of
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orders, the order price (e.g., market order, limit order, short sell)
The length of time the order is to be outstanding (for non-
market orders). *Trading through a brokerage house or self
The Ecology of Financial Markets: Trading Mechanism
An investor should consider the following factors while trading:
Bid-ask Spread: the difference
Price (p) Qs(p)
Qd(p) b/w the price paid by the
purchaser and the price
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received by the seller (pb–pa);
an indicator of liquidity.
pa
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pb
Qe
N Quantity (Q)
Flow of demand and supply for a single asset in a quote-driven market
The Ecology of Financial Markets: Trading Mechanism
An investor should consider the following factors while trading:
• Trade types:
Information traders: those who believe that the prices are incorrect,
take advantage of mispricing; such traders can drive price movements if
they have superior information. What about noise traders?
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Liquidity traders: Those with a surplus of/need for money; e.g.,
liquidate shares for purchasing an asset, or buy shares to park extra
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fund as stocks are good investments.
• Trading costs:
Three major sources of transaction costs: brokerage or
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commission and taxes (direct costs), bid-ask spread, and
price impact of a large sale/purchase.
Vary with security types, trading platforms, and trade size.
• In financial markets, the law of demand and supply largely determine the
prices of securities.
• Markets facilitate trading of financial securities by way of providing price
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discovery, trading mechanism, and settlement of trades.
• An investors should take a note of several factors such as bid-ask-spread,
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types of trades, and trading costs.
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• Investments Principles and Concepts, Jones (2020)
• Bauchaud et al. (2018); Original source: “6” by Alexandre Laumonier
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