2. Financial Market Basics:Motives for Trading> Utilitarian•Trade to achieve benefits other than profits.•Profit-motivated •Trade to profit mainly.

•Not all traders earn

profits on average though.•Unskilled profit-motivated traders •Trading is a zero-sumgame •Utilitarian traders and unskilled profit-motivated traders lose on average to skilled
profit-motivated traders. Utilitarian Traders>1.They trade–To move cash over time–To exchange assets–To hedge–To gamble–To avoid taxes 2.For other reasons•Because of the utility
they derive, they are willing to lose money in trading 3• They are also called “liquidity” traders as they seek liquidity to achieve their desired objective. (sometimes also called
“noise” traders or “uninformed” traders) Profit Motivated Traders 1.•They trade to make a profit.•Buy low and sell high 2.•Speculators profit from predicting future price
movements .a)Informed about the fundamental values (“informed” traders b)Informed about the motives of other traders (“parasitic” traders)c) Uninformed speculators
3.Dealersprofit from offering liquidity (opportunities to trade) to other traders.4. On average, they profit; else they will not trade. Informed Traders 1.Trade when price
differs from their estimates of fundamental values.2.They derive their estimates:a)by collecting new information b)by processing information more effectively3.Their actions make
prices more efficient. 4They can be a)Value traders / News traders / Technical traders / Arbitrageurs Parasitic Traders 1•They trade because they expect other traders to
trade.>Based on realinformation>Order anticipators>a)Short squeeze b)Front runners2.Based on falseinformation>Bluffers>Price manipulators3.They profit at the expense of
both uninformed and informed traders. Dealers 1•They facilitate trades by providing immediacy(“liquidity”) to impatient traders a)For small sizes (Market makers) b)For large
sizes (Block facilitators)2.They profit from trading with uninformed traders but lose to informed traders 3.They need to manage inventory risk >Most like to go home “flat”
Rationality in Financial Markets 1•Rational vs. Irrational Decisions a)Rational –driven by economic considerations b)Irrational –driven by culture/psychology/neuroscience
2•Rational responses are predictable and can be contracted in markets 3•Irrational responses may or may not be predictable and mostly cannot be contracted Rational
Responses in Markets 1.Information asymmetry a)Moral hazard (e.g., incentive compatible contracts) b)Adverse selection (e.g., signaling/screening mechanisms like third party
credit rating etc.) 2.Externalities (e.g., proper tax structure) Irrational Decision Making 1.Individual bias examples a)Anchoring and framing bias b)Loss aversion (disposition
effect)2.Group bias example •Herding (Markets can remain irrational longer than you can remain solvent) Orders : An orderrepresents intent to trade & A trade represents
the fulfillment of that intent Market Orders: 1.They demandan opportunity to trade a)They demand immediacy (i.e. demand liquidity) 2.Execution is certain but price is
uncertain a)They buy at or above the “offer” b)They sell at or below the “bid” 3.They have market impact as they can move prices a)Often, price improvement is possible 4.Small
traders typically payone-half of the bid-ask spread for demanding liquidity Cost of Trading Small Sizes using Market Orders 1•Cost of an instantaneousround-trip trade
(hypothetical) a)Buy at the ask/offer b)Sell at the bid immediately 2•Since it is instantaneous, there is no change in the underlying value of your security 3•So whatever the loss
you face must be entirely due to trading (just buying and selling without any change in value) 4•Cost of trading a round-trip trade = (offer –bid) 5•Cost of trading just one leg =
(offer –bid)/2 6•Bid-ask spread = (offer-bid) Limit Orders: 1.They supply opportunities to trade a)They offer immediacy (liquidity) to market orders 2.Execution price is
certain but execution is uncertain a)They buy at or below the limit price b)They sell at or above the limit price 3.They have little price impact 4.Small traders earn one-half of the
bid-ask spread 4.They can be a)Behindthe market (below the bid or above the offer)b)At the market (at the bid or offer) c)Insidethe market (between the bid and offer)>Limit
orders at or inside the market are “marketable”5.They can be a)Day orders (cancelled at the end of the day if not executed) b)Good-till-cancelled orders6.Limit orders provide
freeoptionsto others a)Limit buy is like selling a put option b)Limit sell is like selling a call option c)Limit price = Strike price d)Option maturity = Time to cancellation or order
expiration Order Queue in the Market : 1.Bid = highest price among buyers 2.Ask/offer = lowest price among sellers Order Submission Strategy Involves broadly>Order
type>Pricing >Backup for delayed or no execution •Depends on >Trader needs >>Time constraint / Information / Ability to monitor. Market conditions >Volatility / Design
considerations . Buy (Sell) liquidity when it is cheap (costly) Market Organization Methods >Quote-driven Markets •Dealers supply all the liquidity (no waiting time for
traders) and earn the bid-ask spread >Buy from sellers at the bid >Sell to buyers at the offer•Competition impacts spreads >Monopoly or collusion will widen spreads>Free entry
and exit of dealers•Examples >All OTC markets (e.g., FX markets, most fixed income and credit markets) >Equity markets in some countries Order-driven Markets •Traders
place orders •Traders are matched in batchesor in a continuousmanner •Traders receive a uniformprice in batch auctions while they may get differentprices in continuous
auctions. •Priority rulesare used in continuous auctions to queue traders•Maintenance of a limit order book•Clearing house is needed to minimize counter-party risk•Examples
•NYSE/Nasdaq•BSE/NSE •Most world markets like Paris Bourse, LSE etc. Uniform Price Matching Scheme • Single price that clears buyers and sellers • Usually the price
that maximizes volume • Used mostly in markets during special times (e.g. Treasury auctions) Discriminatory Pricing Scheme •Different traders pay different prices as they
arrive in the market•Incoming order is matched with the best standing order•Used in continuous markets •Trading is usually stopped if orders blow through prices•Most markets
(e.g., NYSE, NASDAQ, NSE and BSE) follow this rule during the day. Discriminatory pricing produces greater volume but may often lower gains from trade. • Some matching
systems use prices from another market to match its orders. (e.g. ITG’s POSIT in the US) Importance of TickSize : If traders can get price priority by paying a small price,
traders will be reluctant to display true sizes. Trade Information Dissemination •Time and sales data •Time-stamped record of trade with information on quantity and price.
•Mostly available for trades done on an exchange.•Reported with or without a delay.•Sometimes there are differences in reporting requirements for large and small trades.•Trade
dissemination mechanisms •Market-wide consolidated tape provided through regulation•Exchange proprietary feeds•Third-party feeds like Bloomberg and Reuters.

Commodity Markets: Commodity Valuation/Pricing Factors affecting valuation •Demand and supply (immediate and future) •Nature•Cost of storage• Cost of funding
(Factors affecting pricing (in addition to the above)•1.Liquidity imbalances•2.Speculation ▫a)Cornering (Hunt Brothers in Silver, Hamanakain Copper etc.)▫b)Insider trading
Eddie Murphy Rule : ban insider trading using non-public information misappropriated from a government source Commodity Prices Over Time : Long period of
depressed commodity prices• Slow uptick from 2016•Impact of China, US and Indian demand• Impact of ETF and other fund flows on prices Commodities Market
Participants : 1.Primary Demanders and Hedgers (Corporates, Farmers etc.)2•Managed money investors•a)Commodity pool operators (CPO)•b)Commodity trading advisors
(CTA)c)•Index/ETF managers3.Brokers (including Futures Commission Merchants or FCMs)a)•Arrange trades for clients4.•Prop traders (Dealers, Scalpers, Day traders etc.)
a) Trade for their own account.5•Futures exchange a)Futures contracts trade in only one exchange (single listing).6 Clearing house a)Guarantees trades and conducts daily
settlement.