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An Index-Contingent Trading Mechanism: Economic Implications

Author

Listed:
  • Avi Wohl
  • Shmuel Kandel

Abstract

In many stock exchanges around the world there is a "call" or "batch" transaction at the opening of the trading day. Currently, an essential problem in the application of this trading mechanism is that orders in one security cannot be conditioned on prices of other securities. As a result, precise portfolio considerations cannot be based simultaneously on the prices of all securities, and there is no way to trade an asset instantly on the basis of information derived from prices of other securities. Wohl (1994) suggests and analyzes the feasibility of a trading mechanism that facilitates conditioning on an index (a weighted average of stock prices) that is determined simultaneously with the prices of all assets. In this paper we analyze the economic implications of an index-contingent trading mechanism in the framework of rational expectations equilibrium models with liquidity traders. We show that an index-contingent trading mechanism may contribute to the efficiency of prices and to the reduction of losses and risks sustained by liquidity traders. In particular, we compare two trading systems, with and without index-conditioning, and find that in the system with index-conditioning (i) price fluctuations around "true" values are lower, (ii) expected trading costs of liquidity traders are lower, (iii) the variance of the payoffs to the liquidity traders is lower, (iv) the expected utility of informed traders is lower, and (v) the expected volume of trade is higher than in a model without cross-conditioning.

Suggested Citation

  • Avi Wohl & Shmuel Kandel, "undated". "An Index-Contingent Trading Mechanism: Economic Implications," Rodney L. White Center for Financial Research Working Papers 09-94, Wharton School Rodney L. White Center for Financial Research.
    • Handle: RePEc:fth:pennfi:09-94
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