Q.2. Consider Some Stocks That Trade In Two Markets, With A Trader Being Able To Trade In These Stocks In Either Market.

Consider some stocks that trade in two markets, with a trader being able to trade in these stocks in either market. Suppose that the two markets are identical in all respects except that bid–ask spreads are lower and depths (the number of shares being offered at the bid and ask prices) are greater in one of the two markets. State in which market liquidity-motivated and information-motivated traders would prefer to transact.

Answer: Liquidity-motivated traders transact only to meet liquidity needs and desire low transaction costs. So, they would prefer the market with the lower bid-ask spreads. The information-motivated traders trade strategically to maximize the profits from their information. Some of their profits are made in trades in which liquidity-motivated traders are the counterparty. Since the liquidity-motivated traders trade in the market with the lower spreads, information-motivated traders will trade with them in that market. Also, information-motivated traders prefer to place larger orders to profit from any superior information they have.

Such traders with large orders are particularly concerned about the market impact cost in the form of a price change for large trades. Since the quoted prices are firm for only a fixed depth, larger orders may move the bid (ask) price downward (upward). In a market with greater depth, the market impact cost is less. Thus, the market with greater depths would be preferred by information-motivated traders. Overall, between the two alternate trading venues, the one with lower spreads and greater depths would be preferred by both types of traders.

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