market microstructure. the fundamental question of market microstructure: zhow does information get...
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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
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50.3
10 20 30 40 50 60 70 80 90 100
EVA EVB
49.9
50.0
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50.3
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
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2 4 6 8 10 12 14
EVAEVANEVA2N
EVA3NEVA4NEVA5N
ASK QUOTES AFTER A SEQUENCE OF BUYSWITH INTERVENING NONTRADES
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