MARKET MICROSTRUCTURE

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MARKET MICROSTRUCTURE
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THE FUNDAMENTAL QUESTION OF MARKET MICROSTRUCTURE

• HOW DOES INFORMATION GET INCORPORATED INTO
  PRICES??

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FUNDAMENTAL QUESTION

• HOW DOES INFORMATION GET INCORPORATED INTO
  PRICES?
• ECONOMISTS ANSWER IN GENERAL MARKETS IS
  UNSATISFACTORY

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HOW DOES THIS WORK?

• Auctioneer?
• Who knows what?
• Where does new information show up?
• What is the role of time in this market?

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Role of Time

• Random buyers and sellers with various desired
  quantities
• Someone must wait
• Markets where sellers wait
• Markets where buyers wait
• Intermediaries

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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.

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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.

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ADDITIONAL COSTS

• Risk of Bankruptcy
• Risk of Price Changes
• Risk of Trading with Informed Traders

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COMPETITION

• Competition between wholesalers restricts the
  spread
• NASDAQ- Competing market makers
• NYSE - Specialist is a regulated monopolist but
  limit orders provide competition
• Regional Exchanges
• Global competition across exchanges

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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

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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.

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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

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Buy orders Permanently raise prices

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

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Easley and OHara(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

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Easley Kiefer and OHara

• 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

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