The Internal Call Market: A Clean, Well-Lighted Place to Trade

Frederick Grauer and Terrance Odean

Abstract

Large index fund managers provide internal markets in which their clients can trade baskets of stocks. Trading volume in these markets is large. (In 1992 the volume in one internal market was over $44 bllion.) Trading is non-continuous and takes place at periodic fund openings. Securities are traded at their market closing price. The internal market is inexpensive. There are no bid-ask spreads, no commissions (beyond the annual management fee) and no direct market impact from trading. The internal market is a relatively risk-free place to trade, that is, the chance of trading with a better informed counter-party is low. The overwhelming majority of fund participants are pention funds which trade for liquidity reasons and, because entire baskets of stocks must be traded, it is difficult for others to profit from assymetric information. We develop a model for a commission-free call market with exogenously determined price. We find that, when the alternative is to trade in a market with commissions, the savings offered by such a market increase with the square-root of the number of market participants. Savings also increase with the time between fund openings, but so, too, do the opportunitity costs of waiting to trade. We calculate the optimal time between fund openings for risk-neutral investors and for a particular class of risk-averse investors.


Home | Curriculum Vitae