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The Cost of Uncertainty

Traders Magazine Online News, March 12, 2019

Paul Daley

Traders are asked to price financial assets all day every day. Sometimes this is easy and mechanical. Information about the asset is well understood and embedded in past prices. Past prices are very recent and very plentiful. There is a wide consensus about the value of the asset. All the trader needs to do now is account for the new information he has. That new information might be as basic as someone who wants to buy or sell some incremental amount of the asset for some reason.

Other times the task is incredibly difficult. There is significant new information about the asset, but the implications of that information are not yet well understood or well agreed upon by the market. The event is unprecedented, and the asset has almost no history of trades.

The news may be good. A successful private company wants to enter the market with its first publicly traded asset. Fortunately for our trader, there is a well-worn path to figure out a price. And there is ample time to do so. A roadshow is scheduled. Meetings with potential investors are held. Financial information is shared. Price negotiations are entered into. And indications of interest are gathered. At the end of this process a market clearing price is determined. Despite the time and information sharing, sometimes the result is unsatisfactory. The asset might immediately trade higher causing the seller to regret leaving money on the table (though sometimes this is by design). Or the price might immediately decline causing the buyer to suffer remorse. But generally, this long, thoughtful process yields satisfactory results for all parties.

Or the news may be bad. It may be a binary event that has been understood to be a possibility, a drug trial may have failed. Or it may come as completely unexpected news with many possible future states for the financial asset all with varying degrees of probability. A town that has issued municipal bonds may have tragically burned to the ground (Paradise, CA). Or those same fires may have created a liability for a public utility that it is unlikely to be able to meet (PG&E). There may be extended negotiations, legislative intervention or

government aid available, but all those things take time and are for traders in the future to consider. Right now, our traderís phone has rung, and a client has demanded a price. How does our trader price uncertainty?

The answer to that question is often revealed in the bid/ask spread for the asset. In the face of uncertainty, the trader will typically widen the spread between their bid and their offer. In equities, where spreads are available on a pre-trade basis, the measurement of this effect is relatively straight forward. In bonds, where pre-trade transparency is not the norm, it can be more difficult to measure.

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