Andreas Park PRO
Professor of Finance at UofT
Discussion by Andreas Park
Paper by Markus Baldauf, Christoph Frei, and Joshua Mollner
Contract offer
price
volume
Contract offer
price
volume
Contract offer
broker learns all exogenous volume v1,...,vT
investor pays broker
trades occur with temporary price impact
Broker
observe volume and then choose order size to maximize expected utility
accept contract if expected utility > reservation utility
Investor
propose contract that minimizes trading cost
payment occurs at T
Lemma 1
If the investor could trade itself, it would follow the VWAP relative to the exogenous volume.
Theorem 1
The VWAP contract is optimal, and under reasonable conditions uniquely so.
*except in a "degenerate" case
pure agency => broker decides
direct market access
broker internalizes and takes risk
broker matches customer orders
pure agency => broker decides
direct market access
broker internalizes and takes risk
broker matches customer orders
Source: Nomura Research Institute, “Asset Management Companies’ Evaluation of Brokers” April 2014 (cited by the authors); for Japanese data
pure agency => broker decides
direct market access
broker internalizes and takes risk
broker matches customer orders
common: single ex ante price
common:
Setup doesn't yet quite match institutions
subtle: in reality, we often see "give me the VWAP" as instructions for agency trades
But paper's premise is an incentive contract, not "instructions"
=> cannot say that the model explains why VWAP is used for agency.
And risk trades commonly have fixed prices
This matters in terms of the applicability and interpretation of the results as the paper develops.
Way forward: decide what kind of paper to write => several options...
write a normative paper:
show that paper's setup is welfare maximal for "risk trades"
how that and how frictions (e.g., regulation) interfere with optimality
expand to match institutions
true agency trades (broker executes but takes no risk)
competing brokers
repeated interactions
e.g., timing no concern
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By Andreas Park
This is a deck that I used at the 2018 Bank of Canada -Laurier workshop on market microstructure in May 2018.