How Should Investors Price a Block Trade?

The episode revealed the extent to which large volumes of trading, even those involving a meme stock, can have a meaningful impact on the market as a whole.

Though many GameStop investors publicly reveled in the opportunity to shift the market, the episode was more the exception than the rule. Typically, individual retail traders don’t put much consideration into how their relatively small trades might affect stock prices. In contrast, institutional investors like hedge funds and pension funds regularly trade in much larger sizes and need to account for the impact of their large orders on prices.

One way that institutional investors try to minimize the outsized influence of their orders is by avoiding anonymous stock exchanges and instead negotiating to trade directly with a dealer. These large, off-market transactions are called “block trades.”

But doing a block trade with a dealer comes with its own risks. Dealers are unlikely to have the best interests of the investor in mind. And even when they agree to a block trade, they will typically hedge by conducting offsetting trades elsewhere—potentially leading to a worse price for the investor.

Amid all this uncertainty, “the question is, ‘How do you price this block trade?’” asks Joshua Mollner, an associate professor of managerial economics and decision sciences at the Kellogg School. Many block trades are priced based on yet-to-be-determined market prices, such as the stock’s closing price or average price. And it’s unclear which prices are the best ones for investors to reference.

To that end, he collaborated with Markus Baldauf of the University of British Columbia and Christoph Frei of the University of Alberta to create a mathematical model designed to figure out the best kind of pricing contract to use for these large trades.

Their model shows that the ideal approach resembles the market’s average price except that it places extra weight on certain price points throughout the day.

“Some weighted average of the opening price, the market average price, and the closing price—while giving the opening and the closing prices a little bit more weight or emphasis—that’s what the optimal contract looks like,” Mollner says.

Market frictions

A simplified version of a block trade, which Mollner and colleagues analyze with their model, goes as follows.

An institutional investor decides to buy into a particular stock and finds a dealer willing to sell the stock in a private transaction. (In a reverse scenario, the investor could be looking to sell instead of buy.) The investor then proposes a contract to determine how the block trade between them will be priced.

But underneath this seemingly straightforward roadmap, there’s friction at play between the investor and dealer.

“The dealer, by deciding how exactly he wants to schedule his hedging trades, might be able to influence, say, the market’s closing price or the market’s average price or whatever pricing benchmark the investor is using to price this block trade,” Mollner says. “And so that’s where the conflict comes in.”

The investor might prefer the dealer to hedge in a certain way but has no way to ensure that directly. “A dealer’s hedging trades, in some sense, are his own business,” Mollner says. “Trading is anonymous in these markets, so it’s impossible for the client to know exactly how the dealer’s hedging.”

More than a simple average

In designing a contract with the dealer, the investor has several options.

For instance, the investor might agree to pay the dealer whatever the stock’s opening price is. At first glance, this might seem like a good way to go. Since the dealer’s hedging trades would push up market prices, the opening price is likely to be the lowest price of the day. An investor might think it makes sense to lock in this price for the block trade. In that scenario, however, the dealer would likely make sure to hedge by buying right at the open. This would inflate the opening price and therefore increase what the investor pays in the block trade.

“As the investor, you don’t want the dealer to do all of his hedging at the opening price because it creates this problem of concentrating the trading at one point in time, and that’s going to create a lot of price impact,” Mollner says.

An alternative might be to use the stock’s average price. This can be a better option for the investor because it can change how the dealer will hedge. Rather than doing all their hedging at the open, the dealer will likely respond by buying more evenly throughout the day, reducing price impact.

“The key is that the dealer’s hedging behavior will respond to the contract,” Mollner says. “Once you take that into account, the investor will actually pay a lower price by contracting on the average price than on the opening price.”

Yet the investor can do even better than that, according to the model.

It considered all possible variations in block trade contracts to identify which would give the investor the best financial outcome, assuming that the dealer would fully hedge. It found that the optimal contract puts most of the weight on the opening and closing prices of the stock and evenly distributes the rest of the weight on prices throughout the day—a pricing structure that almost mirrors the shape of a “U.”

“It looks a bit like you’re pricing the block trade at the average price,” Mollner says, “but then you put a little extra weight on the opening and close so it’s not just a simple average; it’s a simple average with extra weights.”

This approach helps align the investor’s and dealer’s competing incentives.

Putting a lot of the weight on the closing price decreases the dealer’s incentive to front-load their hedging purchases and encourages the dealer to spread out their trades more evenly throughout the day instead. Certainly, putting extra weight on the closing price would seem to raise the amount that the investor has to pay. But due to the delayed and more evenly distributed hedging, the investor’s costs still turn out to be lower overall.

“That was one insight that came out of the model that we didn’t necessarily anticipate going in,” Mollner says.

It comes down to real money

The researchers performed a back-of-the-envelope calculation to compare the cost effectiveness of the model’s proposed contract against two common types of contracts: one following the stock’s average price over a period of time and one based on the market’s closing price.

They found that the cost using the model’s preferred contract would be 9.8 percent lower than using the “average-price” contract and 40.1 percent lower than using the “close-of-market” contract.

“For trades of the size that we’re talking about, that can be significant,” Mollner says. For a block trade valued at $100 million, this would amount to savings of hundreds of thousands of dollars.

Ultimately, Mollner notes, these costs come out of the pockets of people who are investing in big funds, like a pension fund or an investment fund that tracks the S&P 500.

“Even though the effects on any individual maybe are not that huge—we’re talking about a couple basis points here, a couple basis points there—it’s a lot of individuals,” he says. “And at the end of the day, it aggregates to real money.”