LOS d: Compare and contrast the roles of brokers and dealers.

Q1. Which of the following relationships is adversarial?

A)   Broker and dealer.

B)   Trader and dealer.

C)   Trader and broker.

Q2. In which of the following is there a principal-agent relationship?

A)   Broker and dealer.

B)   Trader and dealer.

C)   Trader and broker.

Q3. In which of the following relationships does the adverse selection risk problem pertain?

A)   Trader and broker.

B)   Trader and dealer.

C)   Trader and investor.

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Q1. Which of the following relationships is adversarial?

A)   Broker and dealer.

B)   Trader and dealer.

C)   Trader and broker.

Correct answer is B)

The relationship between a trader and a dealer is adversarial. The dealer would like to maximize the trade spread and the trader would like to minimize it. Also, when a trader has information that the dealer does not, the trader profits at the dealer’s expense.

Q2. In which of the following is there a principal-agent relationship?

A)   Broker and dealer.

B)   Trader and dealer.

C)   Trader and broker.

Correct answer is C)

A principal-agent relationship exists between a trader and the broker. The broker acts as the trader’s agent and locates the necessary liquidity at the best price. The trader can also extract information from the broker regarding the depth of a market and the identity of other traders.

Q3. In which of the following relationships does the adverse selection risk problem pertain?

A)   Trader and broker.

B)   Trader and dealer.

C)   Trader and investor.

Correct answer is B)

A trader is more likely to trade with a dealer when he has information that the dealer does not. This results in adverse selection risk for the dealer. The trader’s profit is the dealer’s loss once the information is revealed to the market.

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