Auctions and Investing
Auctions are used as a mechanism of price discovery and a way to determine the equilibrium price. There are a variety of types of auctions, each with their own unique traits when it comes to selecting a winner and determining the price they must pay when they win. Note, this material has been de-emphasized in 2018 onwards.
A few pieces of terminology before we examine the different types of auctions:
In a common value auction the value of the item being sold (an oilfield, the # of coins in a jar) will be the same to each buyer, but the bidders don’t know, and hence must estimate, the value of the item. Because of the estimation error this can lead to the winner’s curse where the winner wins the auction but overpays and thus loses money.
In a private value auction the value of the item depends on the buyer’s perception of value rather than intrinsic value. The most common example of this would be an art auction.
The reservation price is the highest price a bidder is willing to pay.
Types of Auctions (by Mechanism)
Ascending Price (English) Auction
What: The “classic” auction. The auctioneer starts with a low price and continues to raise it as long as higher bids come in. The bidding stops when nobody is willing to bid higher, and the winner is the first person to bid at the highest price.
Cons: The seller may not obtain the highest possible price, Buyer may be subject to winner’s curse
Sealed Bid Auction
What: Each bidder provides one bid that is unknown to the other bidders. The bidder with the highest bid wins the auction.
Cons: The optimal bid is just higher than the next bidder’s reservation price, meaning buyers may not actually bid their reservation price. Winner’s curse
Second Price (Vickery) Sealed Bid Auction
What: Each bidder provides one bid that is unknown to the other bidders. The bidder with the highest bid wins the auction BUT pays the bid price of the second highest bidder. Thus there is no reason to bid less than your reservation price.
Descending price (Dutch) Auction
What: The auctioneer starts by offering a very high price for an item and lowers the price until one bidder agrees to purchase the item. If there are many units of an item available the bidder will specify how many units they agree to purchase at a given price. In a modified Dutch auction
all of the winners will pay the same price and that price is set as the amount paid by the bidder who wins the last units. A modified Dutch auction is often the mechanism used for stock buybacks. Here a firm solicits offers from shareholders about how many shares they are willing to purchase at a given price. They then determine the price they need to pay to buy back the requisite number of shares and purchase the shares at that price.[i]
Single Price Auction
This is the auction used to place U.S. Treasuries. For example the government would announce they are selling $100 million of T-Bills. Bidders would then submit either non-competitive bids, which is where they state the total value that they are willing to purchase at the ultimate yield at which all securities are sold, or competitive bids, which is where they state the value and price at which they are willing to purchase. The bids are then ranked in ascending order of yield (or descending order of price). If the offering amount = total bids then all the treasuries are sold at that given yield. If the buyer demand > supply they will buy a proportionally smaller amount than demanded.[ii]
The Types of Auctions found in the CFA Curriculum
[i] And shareholders who specified prices higher than the firm needs to pay will not have their shares purchased.
[ii] Excess Demand = Total bids – total amount offered and excess supply = total amount offered – total bids