1. (Econ 512): Economics of Financial Markets Chapter Two: Asset Market Microstructure Dr. Reyadh Faras Econ 512 Dr. Reyadh Faras

2. 2.1 Financial Markets: functions and Participants  Market: any set of arrangements that enables voluntary agreements to be reached among its participants.  Functions of financial markets: 1)Disseminate information, thus promoting price discovery. 2)Provide a trading mechanism, thus facilitating the making of agreements. 3)Enable the execution of agreements (settlement function). The market should ensure that the terms of agreement are honored: a) confirm the transaction, b) clear the trade, c) settle accounts. Econ 512 Dr. Reyadh Faras

3.  Markets Participants: 1)Public investors, who ultimately own the assets and are motivated returns on assets. 2)Brokers, who act as agents for public investors and motivated by fees received for the services they provide. 3)Dealers, who do trade on their own accounts and motivated by profits from trading assets.  Some dealers are called market makers: they have obligations to ensure that the trading mechanism functions smoothly.  They are granted privileged access to certain administrative procedures or market information Econ 512 Dr. Reyadh Faras

4. 2.2 Trading Mechanisms 2.2.1 Quote-driven markets  Known also as dealer markets, are those in which dealers quote bid and ask (or offer) prices at which they are prepared to buy or sell, respectively, specified quantities of the asset.  They require little formal organization but need mechanisms for publicizing the dealers price quotations, for regulating the conduct of dealers and for administering the settlement of contracts. Econ 512 Dr. Reyadh Faras

5. Figure 2.1: Flow demand and supply for a single asset Econ 512 Dr. Reyadh Faras

6. 2.2.2 Order-driven markets  Known also as agency or auction markets, the mechanism modelled as double auctions, in which participants issue instructions that specific auctions should be taken in response to the arrival of publicly verifiable information, such as price observation.  Prices then adjusted by an auctioneer until the total orders to buy equal the total orders to sell.  In continuous auction markets, public investors direct their orders to brokers contingent upon observations made by broker when the order is executed. Econ 512 Dr. Reyadh Faras

7. 2.4 Trading and asset prices in a call market  In a call market model, market participants are divided into three groups: a)Informed investors, b) uniformed investors; and c) market makers (M-M).  Investors are interpreted as public investors, while M-Ms exist to ensure that a price that balances the purchases and sales of public investors are realized. All are risk neutral.  Exchanges of assets take place for 2 reasons:  a) an information motive: investors trade seeking gains according to their beliefs about future payoffs from assets. Econ 512 Dr. Reyadh Faras

8. b) a liquidity motive: encompassing other reasons including circumstances in which investors sell assets to raise funds for consumption or to meet unforeseen contingency, or when savings flows are invested in traded assets.  In the model, both motives are attributed to uninformed investors whose actions are exogenous and random.  The traded amount by uniformed investors, U, is a normally distributed random variable with expectation (0) and variance σ 2 u : U ~ N(0, σ 2 u ).  There is one informed investor who wants to benefit from information he has about asset price. Econ 512 Dr. Reyadh Faras

9.  Market makers and informed investors know that the value of the asset (V) is determined according to a normal distribution with expectation (μ v ) and variance (σ 2 v ): V ~ N(μ v, σ 2 v ).  Informed investors’ advantage is knowing the outcome (v), not its distribution as M-Ms do.  M-Ms don’t observe (v) but observe total trade (y) by informed and uniformed.  M-Ms are competitive (earn zero profit).  Informed trader learns (v) and trade (x) assets.  Uninformed trader chooses to trade (u).  M-Ms receive orders from investors: y = u + x and then set the market price. Econ 512 Dr. Reyadh Faras

10.  Kyle (19885) shows that:  Market price: p(y) =  Amount traded by informed investors: x(v) =  Model insights: 1.Asymmetry of information generates trade and M-Ms set prices to equilibrate markets. 2.The relative importance of informed and uniformed traders affects the market price. 3.The model can be interpreted as a theory of insider dealing, the informed investor is the insider. Econ 512 Dr. Reyadh Faras

11. 2.5 Bid-ask spreads: inventory-based models  Price quotations are determined by the need for M- Ms to hold inventories of the asset to satisfy flow of demands and supplies from public investors.  The main influences on the bid-ask spread are: 1.Costs of holding inventories (opportunity cost). 2.Market power (bid prices lower & ask prices higher, than otherwise). 3.Risk aversion (M-Ms avoid the prospect of zero inventory). Econ 512 Dr. Reyadh Faras

12. 2.6 Bid-ask spreads: information-based models  The analysis highlights: a) asymmetry of information between informed and uninformed investors, and b) M-Ms cannot distinguish between informed and uninformed investors.  Assume M-M incurs zero transaction costs, is risk neutral and hah no market power.  Informed investor (insider) makes profit at the expense of the M-M (who executes the order) because he knows more about the asset’s value.  If only informed investors trade, M-Ms cannot survive and the market collapses.

13.  M-Ms know the probability that an uninformed trader has issued the order.  Implication: M-Ms will quote a non-zero bid-ask spread.  Reason:  In dealing with informed investors M-Ms incur a loss, while in dealing with uninformed investors each M-M would earn zero expected profits if the bid price equals the ask price  Thus, by quoting ask prices higher than bid prices, M-Ms can, on average, gain in their dealings with uniformed investors. This offsets the expected loss from trading with informed investors.

14.  Competition between M-Ms ensures zero expected profits.  Learning can be built into the evolution of prices.  Each M-M has prior belief about the asset price, which he uses as an input in setting bid and ask prices. Econ 512 Dr. Reyadh Faras