market microstructure. the fundamental question of market microstructure: zhow does information get...
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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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P Demand
Supply
Q
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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 waitMarkets where sellers waitMarkets where buyers waitIntermediaries
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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 makersNYSE - Specialist is a regulated
monopolist but limit orders provide competition
Regional ExchangesGlobal 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
askPnewbuyhistorypastValueE )(
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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 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
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BEGINNING OF DAY
P(INFORMATION)=P(GOOD NEWS)=
P(AGENT IS INFORMED)=P(UNINFORMED WILL BE BUYER)=
P(UNINFORMED WILL TRADE)=
END OF DAY
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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
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49.9
50.0
50.1
50.2
50.3
10 20 30 40 50 60 70 80 90 100
EVA EVB
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49.9
50.0
50.1
50.2
50.3
10 20 30 40 50 60 70 80 90 100
EVA EVB
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50.00
50.05
50.10
50.15
50.20
50.25
50.30
2 4 6 8 10 12 14
ASK1ASK_EKO
ASK2ASK3
ASK4
ASKING QUOTES WITH VARIOUS FRACTIONSOF INFORMED TRADERS
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50.00
50.05
50.10
50.15
50.20
50.25
50.30
2 4 6 8 10 12 14
EVAEVANEVA2N
EVA3NEVA4NEVA5N
ASK QUOTES AFTER A SEQUENCE OF BUYSWITH INTERVENING NONTRADES