MARKET MICROSTRUCTURE

THE FUNDAMENTAL QUESTION OF MARKET MICROSTRUCTURE: zHOW DOES INFORMATION GET INCORPORATED INTO PRICES??

FUNDAMENTAL QUESTION zHOW DOES INFORMATION GET INCORPORATED INTO PRICES? zECONOMISTS ANSWER IN GENERAL MARKETS IS UNSATISFACTORY

HOW DOES THIS WORK? zAuctioneer? zWho knows what? zWhere does new information show up? zWhat is the role of time in this market?

Role of Time zRandom buyers and sellers with various desired quantities zSomeone must wait zMarkets where sellers wait zMarkets where buyers wait zIntermediaries

Wholesaler zIn 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 zTHE 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 zRisk of Bankruptcy zRisk of Price Changes zRisk of Trading with Informed Traders

COMPETITION zCompetition between wholesalers restricts the spread zNASDAQ- Competing market makers zNYSE - Specialist is a regulated monopolist but limit orders provide competition zRegional Exchanges zGlobal 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 zBuy 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 xGLOSTEN AND MILGROM(1985) following Bagehot(1971) and Copeland and Galai(1983) xA fraction of the traders have superior information about the value of the asset but they are otherwise indistinguishable. zMARKET MAKER INFERENCE PROBLEM: xIf the next trader is a buyer, this raises my probability that the news is good. Knowing all the probabilities I can calculate

Buy orders Permanently raise prices zOver time, the specialist and the market ultimately learn the information and prices reflect this.

Easley and O’Hara(1992) zThree possible events- Good news, Bad news and no news zThree possible actions by traders- Buy, Sell, No Trade zSame updating strategy is used

Easley Kiefer and O’Hara zEmpirically estimated these probabilities zEconometrics involves simply matching the proportions of buys, sells and non- trades to those observed. zDoes not use (or need) prices, quantities or sequencing of trades