MARKET MICROSTRUCTURE

THE FUNDAMENTAL QUESTION OF MARKET MICROSTRUCTURE:

HOW DOES INFORMATION GET INCORPORATED INTO PRICES??

FUNDAMENTAL QUESTION

HOW DOES INFORMATION GET INCORPORATED INTO PRICES?

ECONOMISTS ANSWER IN GENERAL MARKETS IS UNSATISFACTORY

P Demand

Supply

Q

HOW DOES THIS WORK?

Auctioneer?Who knows what?Where does new information show

up?What is the role of time in this

market?

Role of Time

Random buyers and sellers with various desired quantities

Someone must waitMarkets where sellers waitMarkets where buyers waitIntermediaries

Wholesaler

In many markets there is a wholesaler who purchases from a producer, holds inventory, and then sells to the retail market. He quotes both buying (bid) prices and selling (ask) prices. The spread compensates him for inventory holding costs.

IN FINANCIAL MARKETS

THE MARKET MAKER OR SPECIALIST TAKES THE ROLE OF WHOLESALER. HE BUYS FROM SELLERS AND SELLS TO THE BUYERS. HE HOLDS INVENTORY AND CHARGES A SPREAD.

ADDITIONAL COSTS

Risk of Bankruptcy

Risk of Price Changes

Risk of Trading with Informed Traders

COMPETITION

Competition between wholesalers restricts the spread

NASDAQ- Competing market makersNYSE - Specialist is a regulated

monopolist but limit orders provide competition

Regional ExchangesGlobal competition across exchanges

INVENTORY MODELS

GARMAN(1976) - Poisson orders to buy or sell. Price is fixed. Certain bankruptcy is avoided by spread.

AMIHUD AND MENDELSOHN(1980) – bid and ask prices are functions of inventory

STOLL(1978) – dealer is risk averse and must be compensated by spread for deviations from optimal inventory

Three different reasons for spreads – avoid bankruptcy, exercise market power, and compensation for risk

Price Behavior

Buy orders lead to temporary price increases because they reduce inventories which can only be replenished by raising the price to encourage some sellers.

ASYMETRIC INFORMATION MODELS

GLOSTEN AND MILGROM(1985) following Bagehot(1971) and Copeland and Galai(1983)

A fraction of the traders have superior information about the value of the asset but they are otherwise indistinguishable.

MARKET MAKER INFERENCE PROBLEM:If the next trader is a buyer, this raises my

probability that the news is good. Knowing all the probabilities I can calculate

askPnewbuyhistorypastValueE )(

Buy orders Permanently raise prices

Over time, the specialist and the market ultimately learn the information and prices reflect this.

Easley and O’Hara(1992)

Three possible events- Good news, Bad news and no news

Three possible actions by traders- Buy, Sell, No Trade

Same updating strategy is used

BEGINNING OF DAY

P(INFORMATION)=P(GOOD NEWS)=

P(AGENT IS INFORMED)=P(UNINFORMED WILL BE BUYER)=

P(UNINFORMED WILL TRADE)=

END OF DAY

Easley Kiefer and O’Hara

Empirically estimated these probabilities

Econometrics involves simply matching the proportions of buys, sells and non-trades to those observed.

Does not use (or need) prices, quantities or sequencing of trades

49.9

50.0

50.1

50.2

50.3

10 20 30 40 50 60 70 80 90 100

EVA EVB

49.9

50.0

50.1

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10 20 30 40 50 60 70 80 90 100

EVA EVB

50.00

50.05

50.10

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2 4 6 8 10 12 14

ASK1ASK_EKO

ASK2ASK3

ASK4

ASKING QUOTES WITH VARIOUS FRACTIONSOF INFORMED TRADERS

50.00

50.05

50.10

50.15

50.20

50.25

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2 4 6 8 10 12 14

EVAEVANEVA2N

EVA3NEVA4NEVA5N

ASK QUOTES AFTER A SEQUENCE OF BUYSWITH INTERVENING NONTRADES