Structure and regulation of financial markets past papers:
2016:
1) The Newbury supermarket group has just made a tender bid of £10 a share for the on-line
retailer Arcost. It is known that Weinhoff is contemplating a knock-out bid of V H =£12. If this
emerges, shareholders will get £12 a share but if it does not the price will fall back to V L=£10. Risk
neutral market makers quote bid and ask prices ( P A and PB ) at which they stand ready to buy up
to 1,000 of shares in Norbrew. Use the King-Roell model to analyse the situation.
(a) Suppose you first observe that P A =£11.10 and PB =£10.90.
(i) what do these prices tell you about the probability (p) of the £12 bid?
P A and PB are centred at the midpoint of V H and V L, revealing that the probability of a bid is p=0.5
(the King-Roell model).
(ii) how much could you make if you were an insider and knew that this higher a bid was to be
made for sure? [2 marks].
I buy 1000 shares at P A and sell for V H to gain:
1000 ×(V H −P A )
1000 × ( £ 12−£ 11.10 )=£ 900
(iii) what is the maximum payment (k) you would be prepared to offer to know for sure whether
this £12 bid was to be made? Assume that the market structure ensures that agents can only trade
once.
With p=0.5, I get £900 (answer ii) and with probability 0.5, I get:
1000 × ( P B−V L ) =£ 900
So k =£ 900
(iv) Find an equation showing how (k) depends upon: p; V L ; V H ; P A and PB
k = p ( V H −P A ) +(1− p)( PB −V L )
(b) Now suppose you observe that P A =PB =£ 11.50. What do these prices tell you about:
(i) the amount of insider trading activity?
“Close” prices indicate that market makers believe that there is no insider trading.
(ii) the probability (p) of a £12 bid?
c) Find an equation showing how the probability of a bid (p) depends upon: V L ; V H and p when
P A =PB =P.
P is the bid-probability weighted average:
P=P A =P B= p V H +(1− p)V L
£ 11.50=12 p+(1− p) 10
£ 11.50=12 p+10−10 p
,£ 11.50=12 p+10−10 p
2 p=£ 1.50
p=0.75
(d) Use your results at a(iv) and b(iii) to derive a condition describing the point at which research-
informed trading stops.
k = p ( V H −P A ) +(1− p)( PB −V L ) (1)
P=P A =P B= p V H +(1− p)V L (2)
PB = p V H +( 1− p)V L (formula 2)
Subtract V L
PB −V L= p V H + (1− p ) V L −V L
PB −V L= p V H +V L − pV L −V L
PB −V L= p V H − pV L
PB −V L= p( V H −V L )
P A = pV H +(1− p) V L
Subtract V H
P A −V H =p V H −V H +(1− p) V L
P A −V H =(−1+ p ) V H +(1−p)V L
P A −V H =−V H + p V H +V L −p V L
P A −V H =( 1− p ) V L +(−1)(−1+ p)(V H )
P A −V H =( 1− p ) V L +(1−p)(−V H )
P A −V H =( 1− p ) (V ¿ ¿ L−V H )¿
Substituting these into ( 1 ) : k= p ( V H −P A )+(1−p)( P B−V L )
k = p (−1 )( 1−p ) (V ¿ ¿ L−V H )+(1− p) p(V H −V L )¿
¿ : x=k /(V H −V L )≤ 2 p(1− p)
Where x is the normalised cost of research which is the cost at which investors are indifferent to
undertaking research and this is described as a quadratic function of p. This is the Bernoulli binomial
uncertainty formula, which is maximised at p=0.5, which is the situation at (a).
(e) Does security research help or hinder the efficiency of the secondary capital markets? What
would happen to the efficiency of the market if research costs were negligibly small?
Secondary capital market prices should (1) clear the market efficiently with minimal bid-ask spread
and (2) make prices as informative as possible. However, these 2 criteria are in conflict. This is
because security research helps to inform prices, however, from the King-Roell (1988) argument,
insider trading increases spreads. This is what happens at (a), although this trade-off is less implicit.
At (b), there is no spread, meaning that the market clears efficiently, but the research cost k>0 stops
prices becoming fully revealing.
,2. Compare and contrast the problems that asymmetric information precipitates in fund
management and banking firms. How are these differences reflected in the different mechanisms
used to regulate these markets?
Retail financial services like fund management services are a credence good, because consumers
must have faith in the provider that they will act in their best interests. Retail financial services have
information asymmetries which leads to both moral hazard, adverse selection and ex-post state
verification. Adverse selection It occurs before any transaction takes place and it may prevent any
deals from occurring. This is because high-quality suppliers realise they are getting a bad deal and
exit the market. This is what Akerlof (1970) and it leads to a downward spiral in price and quality,
which eventually leads to a market collapse. Moral hazard occurs after the transaction has taken
place and behaviour may be monitored. It occurs precisely because a deal has taken place, changing
incentives and behaviour on the demand side. This is when fund managers take excessive risk to
increase the returns for the firm and their own benefit (for bonuses) while investors face the
downside losses. This creates a principal-agent problem. The ex-post state verification occurs after
the transaction has taken place and the final outcome can only be verified at a cost. This means the
final outcome cannot be observed causelessly and its verification could be costly or impossible.
To reduce these information asymmetry problems, regulators have imposed minimum standards and
barriers to entry for fund managers, to ensure only the most able can enter the market and this
reduces the asymmetric information problems. For example, regulators can screen new entrants to
ensure they are high-quality fund managers. Also, forcing fund managers to have professional
qualifications in accounting means the information about their quality is revealed as they will need
high levels of knowledge. These entry barriers raise economic rents and provide an incentive for fund
managers to stay in the industry by behaving well. This is because the FCA can make sure certain
firms are excluded out of the market if they behave poorly and because there is a high cost to enter,
there is an incentive from fund management firms to remain high in quality once they have entered
the market so that they are not forced to exit by the FCA. However, there are negative effects. These
tools are anti-competitive and the prices will be higher than without these tools, meaning some
suppliers will not stay in the market. Also, they are detrimental for those who want to buy or sell low
quality services at low prices because with these tools, it doesn’t allow for a low-quality equilibrium.
Another way to remove information asymmetries is for regulators to force firms to have industry
insurance/compensation schemes for investors. This uses the (Spence, 1973) signalling theory where
only high-quality suppliers can afford industry insurance schemes and this provides a signal to
consumers that these suppliers are high quality. An example is the Financial Services Compensation
Scheme (FSCS). They protect savers and compensates them if their chosen savings provider ceases
trading and is unable to return their funds. This is funded by the banking industry and is backed by
the Treasury. Here, the government pay out as the last resort because this was set up by them. FSCS
protects consumers for up to £85,000 in total across all accounts which you hold within an
institution. Any firm that is authorised by the Financial Conduct Authority (FCA) and the Prudential
Regulation Authority (PRA) is covered by the FSCS. However, these schemes have problems where
high-quality firms subsidise low-quality ones. This is because if the industry goes bad due to so many
low-quality suppliers in the market, it is the high-quality firms with the industry insurance which pay
for this. Also, moral hazard will not be eliminated as customers know they will be compensated for
losses so they will not be careful in choosing which supplier they go to (whether it is low or high
quality).
, Another way is for regulators to monitor and audit financial institutions. In this case, self-regulating
industry bodies or government organisations monitor the providers and force poor quality providers
to improve or exit the industry. This incentivises financial institutions to remain high quality because
the performance of the industry affects the consumer perception of the industry. Also, organisations
are responsible for the insurance scheme pay outs if things go wrong, so it will be costly if the
industry is low quality. However, regulators do not have the ability to monitor and enforce quality
effectively because they are outsiders and find it difficult to monitor complex transactions in these
organisations. They may not have the knowledge to know whether fraud is being committed. Also,
there is the argument that before he financial crisis, the government were regulating financial
services which they didn’t do well because these organisations were being too risky so having to
monitor these complex organisations will be tricky. Despite this, the government have the power to
change the law which would make it easier to enforce quality in the industry. Additionally, even if the
FCA reduces negligence and incompetence, industry insurance and monitoring does not deal
effectively with dishonesty. For example, if suppliers are engaging in fraud, the insurance will still
work. This implies that investors and the financial industry as a whole are exposed to risk and provide
a rationale for government intervention to regulate this industry.
Other methods include capital adequacy, which is the minimum reserves of capital which a financial
institution must have available. This is needed because the market maker is subject to high risks and
depending on which trades are made, there is a risk that they lose on capital. Therefore, ensuring
they have adequate capital will help reduce the risk because it means they do not face financial
trouble and deters low-quality firms to excessively take risk. Additionally, transparency is important
because making information public will reduce information asymmetries, meaning that markets can
operate efficiently.
Overall, information asymmetries create moral hazard and adverse selection problems which can be
mitigated by regulator by implanting industry standards, increasing barriers to entry, monitoring
through audits and by ensuring firms have minimum capital requirements that they must follow.
While these all help to reduce these problems, they have their own limitations such as increasing risk
to the industry and deterring certain firms from entering the market since the costs are so high. This
means the market is not completely efficient.
3. Carefully explain how:
(a) adverse selection can lead to a downward spiral in quality and price in a financial market:
Akerlof (1970) shows how information asymmetry leads to adverse selection, resulting in a
downward spiral in quality and price, using the second hand cars market as the example. He assumes
that cars are either low-quality (lemons) or high-quality (peaches) and this quality is only known to
the seller whereas buyers only know the average quality. He finds that high- and low-quality cars are
sold in the same pooling price which reflects the average quality. This drives high quality cars out of
the market (as their reservation value is higher than the average price). This results in a downward
spiral in price and quality and to a market collapse.
This can be modelled in a financial market through the model of fund management, where suppliers
are the fund managers and demand are the retail clients. Firstly defining the key variables:
Supply side:
x: a fund manager’s actual ability to “beat the market”.
2016:
1) The Newbury supermarket group has just made a tender bid of £10 a share for the on-line
retailer Arcost. It is known that Weinhoff is contemplating a knock-out bid of V H =£12. If this
emerges, shareholders will get £12 a share but if it does not the price will fall back to V L=£10. Risk
neutral market makers quote bid and ask prices ( P A and PB ) at which they stand ready to buy up
to 1,000 of shares in Norbrew. Use the King-Roell model to analyse the situation.
(a) Suppose you first observe that P A =£11.10 and PB =£10.90.
(i) what do these prices tell you about the probability (p) of the £12 bid?
P A and PB are centred at the midpoint of V H and V L, revealing that the probability of a bid is p=0.5
(the King-Roell model).
(ii) how much could you make if you were an insider and knew that this higher a bid was to be
made for sure? [2 marks].
I buy 1000 shares at P A and sell for V H to gain:
1000 ×(V H −P A )
1000 × ( £ 12−£ 11.10 )=£ 900
(iii) what is the maximum payment (k) you would be prepared to offer to know for sure whether
this £12 bid was to be made? Assume that the market structure ensures that agents can only trade
once.
With p=0.5, I get £900 (answer ii) and with probability 0.5, I get:
1000 × ( P B−V L ) =£ 900
So k =£ 900
(iv) Find an equation showing how (k) depends upon: p; V L ; V H ; P A and PB
k = p ( V H −P A ) +(1− p)( PB −V L )
(b) Now suppose you observe that P A =PB =£ 11.50. What do these prices tell you about:
(i) the amount of insider trading activity?
“Close” prices indicate that market makers believe that there is no insider trading.
(ii) the probability (p) of a £12 bid?
c) Find an equation showing how the probability of a bid (p) depends upon: V L ; V H and p when
P A =PB =P.
P is the bid-probability weighted average:
P=P A =P B= p V H +(1− p)V L
£ 11.50=12 p+(1− p) 10
£ 11.50=12 p+10−10 p
,£ 11.50=12 p+10−10 p
2 p=£ 1.50
p=0.75
(d) Use your results at a(iv) and b(iii) to derive a condition describing the point at which research-
informed trading stops.
k = p ( V H −P A ) +(1− p)( PB −V L ) (1)
P=P A =P B= p V H +(1− p)V L (2)
PB = p V H +( 1− p)V L (formula 2)
Subtract V L
PB −V L= p V H + (1− p ) V L −V L
PB −V L= p V H +V L − pV L −V L
PB −V L= p V H − pV L
PB −V L= p( V H −V L )
P A = pV H +(1− p) V L
Subtract V H
P A −V H =p V H −V H +(1− p) V L
P A −V H =(−1+ p ) V H +(1−p)V L
P A −V H =−V H + p V H +V L −p V L
P A −V H =( 1− p ) V L +(−1)(−1+ p)(V H )
P A −V H =( 1− p ) V L +(1−p)(−V H )
P A −V H =( 1− p ) (V ¿ ¿ L−V H )¿
Substituting these into ( 1 ) : k= p ( V H −P A )+(1−p)( P B−V L )
k = p (−1 )( 1−p ) (V ¿ ¿ L−V H )+(1− p) p(V H −V L )¿
¿ : x=k /(V H −V L )≤ 2 p(1− p)
Where x is the normalised cost of research which is the cost at which investors are indifferent to
undertaking research and this is described as a quadratic function of p. This is the Bernoulli binomial
uncertainty formula, which is maximised at p=0.5, which is the situation at (a).
(e) Does security research help or hinder the efficiency of the secondary capital markets? What
would happen to the efficiency of the market if research costs were negligibly small?
Secondary capital market prices should (1) clear the market efficiently with minimal bid-ask spread
and (2) make prices as informative as possible. However, these 2 criteria are in conflict. This is
because security research helps to inform prices, however, from the King-Roell (1988) argument,
insider trading increases spreads. This is what happens at (a), although this trade-off is less implicit.
At (b), there is no spread, meaning that the market clears efficiently, but the research cost k>0 stops
prices becoming fully revealing.
,2. Compare and contrast the problems that asymmetric information precipitates in fund
management and banking firms. How are these differences reflected in the different mechanisms
used to regulate these markets?
Retail financial services like fund management services are a credence good, because consumers
must have faith in the provider that they will act in their best interests. Retail financial services have
information asymmetries which leads to both moral hazard, adverse selection and ex-post state
verification. Adverse selection It occurs before any transaction takes place and it may prevent any
deals from occurring. This is because high-quality suppliers realise they are getting a bad deal and
exit the market. This is what Akerlof (1970) and it leads to a downward spiral in price and quality,
which eventually leads to a market collapse. Moral hazard occurs after the transaction has taken
place and behaviour may be monitored. It occurs precisely because a deal has taken place, changing
incentives and behaviour on the demand side. This is when fund managers take excessive risk to
increase the returns for the firm and their own benefit (for bonuses) while investors face the
downside losses. This creates a principal-agent problem. The ex-post state verification occurs after
the transaction has taken place and the final outcome can only be verified at a cost. This means the
final outcome cannot be observed causelessly and its verification could be costly or impossible.
To reduce these information asymmetry problems, regulators have imposed minimum standards and
barriers to entry for fund managers, to ensure only the most able can enter the market and this
reduces the asymmetric information problems. For example, regulators can screen new entrants to
ensure they are high-quality fund managers. Also, forcing fund managers to have professional
qualifications in accounting means the information about their quality is revealed as they will need
high levels of knowledge. These entry barriers raise economic rents and provide an incentive for fund
managers to stay in the industry by behaving well. This is because the FCA can make sure certain
firms are excluded out of the market if they behave poorly and because there is a high cost to enter,
there is an incentive from fund management firms to remain high in quality once they have entered
the market so that they are not forced to exit by the FCA. However, there are negative effects. These
tools are anti-competitive and the prices will be higher than without these tools, meaning some
suppliers will not stay in the market. Also, they are detrimental for those who want to buy or sell low
quality services at low prices because with these tools, it doesn’t allow for a low-quality equilibrium.
Another way to remove information asymmetries is for regulators to force firms to have industry
insurance/compensation schemes for investors. This uses the (Spence, 1973) signalling theory where
only high-quality suppliers can afford industry insurance schemes and this provides a signal to
consumers that these suppliers are high quality. An example is the Financial Services Compensation
Scheme (FSCS). They protect savers and compensates them if their chosen savings provider ceases
trading and is unable to return their funds. This is funded by the banking industry and is backed by
the Treasury. Here, the government pay out as the last resort because this was set up by them. FSCS
protects consumers for up to £85,000 in total across all accounts which you hold within an
institution. Any firm that is authorised by the Financial Conduct Authority (FCA) and the Prudential
Regulation Authority (PRA) is covered by the FSCS. However, these schemes have problems where
high-quality firms subsidise low-quality ones. This is because if the industry goes bad due to so many
low-quality suppliers in the market, it is the high-quality firms with the industry insurance which pay
for this. Also, moral hazard will not be eliminated as customers know they will be compensated for
losses so they will not be careful in choosing which supplier they go to (whether it is low or high
quality).
, Another way is for regulators to monitor and audit financial institutions. In this case, self-regulating
industry bodies or government organisations monitor the providers and force poor quality providers
to improve or exit the industry. This incentivises financial institutions to remain high quality because
the performance of the industry affects the consumer perception of the industry. Also, organisations
are responsible for the insurance scheme pay outs if things go wrong, so it will be costly if the
industry is low quality. However, regulators do not have the ability to monitor and enforce quality
effectively because they are outsiders and find it difficult to monitor complex transactions in these
organisations. They may not have the knowledge to know whether fraud is being committed. Also,
there is the argument that before he financial crisis, the government were regulating financial
services which they didn’t do well because these organisations were being too risky so having to
monitor these complex organisations will be tricky. Despite this, the government have the power to
change the law which would make it easier to enforce quality in the industry. Additionally, even if the
FCA reduces negligence and incompetence, industry insurance and monitoring does not deal
effectively with dishonesty. For example, if suppliers are engaging in fraud, the insurance will still
work. This implies that investors and the financial industry as a whole are exposed to risk and provide
a rationale for government intervention to regulate this industry.
Other methods include capital adequacy, which is the minimum reserves of capital which a financial
institution must have available. This is needed because the market maker is subject to high risks and
depending on which trades are made, there is a risk that they lose on capital. Therefore, ensuring
they have adequate capital will help reduce the risk because it means they do not face financial
trouble and deters low-quality firms to excessively take risk. Additionally, transparency is important
because making information public will reduce information asymmetries, meaning that markets can
operate efficiently.
Overall, information asymmetries create moral hazard and adverse selection problems which can be
mitigated by regulator by implanting industry standards, increasing barriers to entry, monitoring
through audits and by ensuring firms have minimum capital requirements that they must follow.
While these all help to reduce these problems, they have their own limitations such as increasing risk
to the industry and deterring certain firms from entering the market since the costs are so high. This
means the market is not completely efficient.
3. Carefully explain how:
(a) adverse selection can lead to a downward spiral in quality and price in a financial market:
Akerlof (1970) shows how information asymmetry leads to adverse selection, resulting in a
downward spiral in quality and price, using the second hand cars market as the example. He assumes
that cars are either low-quality (lemons) or high-quality (peaches) and this quality is only known to
the seller whereas buyers only know the average quality. He finds that high- and low-quality cars are
sold in the same pooling price which reflects the average quality. This drives high quality cars out of
the market (as their reservation value is higher than the average price). This results in a downward
spiral in price and quality and to a market collapse.
This can be modelled in a financial market through the model of fund management, where suppliers
are the fund managers and demand are the retail clients. Firstly defining the key variables:
Supply side:
x: a fund manager’s actual ability to “beat the market”.
