1. A limit order market is a real world institution for characterizing the financial sector, and it is also a paradigm for describing almost all trading mechanisms. This lecture defines limit order markets, explains how they work, and gives you some experience trading on a commodities exchange. Then we investigate, analytically and experimentally, the empirical relevance of arbitrage pricing and the efficient markets hypothesis. Lecture 2 Limit Order Markets

2. Financial Markets Electronic limit order markets are amongst the fastest growing markets within the financial and retail sectors. Whether market makers set the spread (NASDAQ), specialists oversee transactions between investors (NYSE), or the market admits anyone in good standing to submit buy and sell orders (EBAY), these exchanges have a common structure. What can we say about the portfolio management when financial assets are traded on a limit order market?

3. Trading in a generic limit order market Traders submit a market order or a limit order. Each order is for a given quantity, positive (negative) quantities standing for units demanded to buy (for sale). Limit orders specify a transaction price, market orders a reservation price. Market transactions match market orders with limit orders, and take place at the limit order price(s). Thus market orders are executed instantaneously, but a limit order might never be executed.

4. Precedence Market orders to buy are matched against the lowest price limit order(s) to sell. If two limit orders to buy are submitted at the same price, the order submitted first is matched against a market sell order before the more recently submitted buy order. Similarly lower priced limit orders to sell have a higher priority than higher priced limit sell orders, and if two bidders seeking to sell a unit at the same price the person who bid first will be matched before his rival seller.

5. Trading window The difference between the highest priced limit buy order ask price (the bid price), and the lowest priced limit sell order (the ask price) is called the spread, here 2,000. The trader just placed a sell order for 9 units at price 5,800, with an expiry time of 60,000 seconds, reducing the spread from 2,200 by placing an order inside the previous bid ask quotes.

6. Many auctions are examples of simple limit order markets In a first price sealed bid auction, bidders place limit buy orders without seeing the book, and the auctioneer fills one of the limit orders with a market sell. In an English auction bidders place limit orders and the auctioneer fills one order with a market sell. In a Dutch auction, the auctioneer places limit sell orders until a bidder fills one of his orders with a market buy. Since an auction is the simplest form of a limit order market, studying behavior in auctions is also a useful way to learn how investors trade in limit order markets.

7. Not all auctions are limit order markets In a second priced sealed bid auction, players simultaneously submit their bids, the highest bidder wins the auction, and pays the second highest bid. Ebay is not technically a second price sealed bid auction, but in practice most Ebay bids are sold to sniping bidders, who bid at the close out time so that no one can respond. Note also that the “Buy it now” part of Ebay is just a limit sell order, in this case the ask price until the bidding closes.

8. Should I place a market order or a limit order? Market orders transact immediately. Limit orders might never transact, but if they do, yield greater gains. Suppose I value the stock at Value and the ask price is Ask. Then the gain from buying the stock is: Value - Ask Suppose I place a limit buy order of B’. Denote the probability of the ask price falling to B’ by Prob[B’]. Then the gain from placing a limit buy order of B’ is: Prob[B’] *{Value - B’}.

9. Keeping track of limit orders Picking-off risk poses an additional hazard for maintaining unattended limit orders. If I place a limit buy order (below the ask), and then the value of it to everyone: 1.increases due to a favorable announcement, then the spread will shift up and my order won’t fill. 2.decreases due to an unfavorable announcement, then the spread will shift down, my order will fill at the price I selected before the unfavorable announcement was made. In other words if I do not keep track of changes in the value of the stock where my orders are placed, then I am more likely to transact when prices move against me.

10. Market makers and specialists Market makers (at NASDAQ) and specialists (at NYSE) play an intermediary role to facilitate the speed with which transactions take place. Market makers compete with each other (about 14 for each type of security) by posting a spread, a bid and an ask, that investors can trade at. Specialists (just one per share) can post a spread at which they must transact at, but must process orders coming from investors in the exact order they are received without interfering with orders that cross.

11. Flash orders and high frequency trading Flash orders give designated insiders (associated with the exchange) an opportunity to react to an outside limit order, before everyone else can. Flash orders are likely to be banned soon. High frequency trading refers to computer programs for placing orders. They are typically based on data analysis designed to identify favorable trading opportunities. The algorithms react very quickly to changes in the book and market conditions.

12. Front Running Specialists on stocks only listed on the NYSE do not compete with each other but only with outside traders for determining trading volume and pricing. If permitted specialists could make substantial monopoly rents by breaking the precedence rule, preventing buy and sell limit orders to cross, and extracting the difference between the buy and sell limit prices. In this illegal maneuver the specialist, rather than the buyer, purchases directly from the seller at the ask price, and then sells the stock to the buyer at the bid price. This illegal practice is punished with jail time.

13. Insider Trading Insider trading laws discourage managers and other associates from using privy information about the firm to their advantage when trading stock. The FTC enforces these laws by reviewing evidence of whether a large volume of shares traded hands just before a financial event, (and in the case of a negative event where there would be a short sale before just after as well) They check to see whether the people who profited might have known one another, who there source might be, and typically use wire tapping procedures for self incriminating statements.

14. Inside information and performance pay Although insider trading is illegal, my research with Prof Gayle on the S&P 1500 composite shows that: 1.Changes in the stock components of the manager’s compensation is a significant predictor of future financial returns, executives opting for more stock and less cash and bonus when the firms they manage subsequently do well. 2.Retrospectively replicating the manager’s compensation strategies and forming a simple investment strategy, we would have earned 20 percent return per year over the 9 year panel for the 1500 firms, instead of the market return of about 9 percent.

15. How efficient are limit order markets? With two other researchers, Prof Hollifield and I conducted an empirical investigation into three stocks previously traded on the Vancouver exchange to see how much of the potential gains from trade are realized in limit order markets. Published in the Journal of Finance, ours is the first study to do this. We chose this exchange for two main reasons: 1. Data Availability of all limit orders rather than just transaction data. 2. This exchange had a “wild west” reputation, so was a good test of how well this market mechanism works.

16. Types of inefficiency Limit order markets for financial securities might not realize all the potential gains from trade for four reasons: 1. Limit orders are not executed when they should be (that is to maximize the total gains from trade). 2. Traders do not submit orders when they should (deterred by the order submission cost and the low probability of execution). 3. Traders submit “wrong sided” orders, such as a buy order rather than a sell order (to profit from stale limit sells after value of stock has risen). 4. Traders submit orders when they should not (because of order submission costs).

17. Recylcing Imagine you are one of about 40 firms in the recycling business. There are four product markets 1. Plastics 2. Metals 3. Glass 4. Paper Your upstream collectors have endowed you with 10 units of each product. You also have $400 of liquid assets (cash) for trading in these four product markets.

18. Valuations You have also developed a network of clients that will buy all your stock at the end of the garbage collection/disposal period, say a week. At the end of the week you dispose of all your recycled material a unit (product specific) price or value that is given to you at the beginning of the game. Let’s call the unit value of plastic units V(Plastic), and so on for the others. You sell each unit of plastic you own at V(Plastic) at the end of the week, and so on. Your values are independently drawn from a uniform distribution with support [0,10]. For example, if you draw V(Plastic) = 9 but V(Metal) = 1, then disposing your plastic is much more lucrative than disposing of your metal.

19. Value of the firm The initial value of your firm is: Cash + 10* [V(Plastic) + V(Metal) + V(Glass) + V(Paper)] Your aim is to maximize the value of your firm at the end of the collection/disposal week. Let’s call the units of plastic you have at the end of the game Q(Plastic). The value of your firm at the end of the collection/disposal period is: Cash + V(Plastic) Q(Plastic) + V(Metal) Q(Metal) + V(Glass) Q(Glass) + V(Paper) Q(Paper)

20. Summary We defined and discussed the main features of limit order markets, including limit orders, market orders, transaction prices and picking off risk. We explained some issues of concern to regulators, such as flash trading, inside trading and front running. We discussed the ways in which inefficiencies in limit order markets might arise, and discussed what the data say about this matter. And we took a first pass at trading in a commodities market.