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The microstructure of financial markets

The book of Harris (2003) serves as an excellent reference manual for understanding the microstructure of financial markets. It covers topics such as market structure, rational expectations models, inventory models, and empirical market microstructure. Additionally, it explores political issues in market organization, limit order markets, price discovery, liquidity, and asset pricing.

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The microstructure of financial markets

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  1. The microstructure of financial markets The book of Harris (2003) is an excellentreference manual (in-depthexaminations)

  2. The microstructure of financial markets European Energy Markets and Activity/Liquidity for 2008 -2009 (annual reports)

  3. Market structure Rational Expectations models Kyle models Glosten-Milgrom models Inventory models Empirical Market microstructure Political issues in market organzation Limit order markets Price Discovery Liquidity and asset pricing

  4. The microstructure of financial markets Institutions and market structure: • Market structures: • Order driven markets • Auction markets • Order matching rules: order precedence rules and trade pricing rules • Call (or batch) markets • Oral auctions (open-outcry in floors or pits) • Electronic auctions • Continuous markets (limit order books) • Crossing networks • Order matching rules: order precedence rules and derivatives pricing rules • Quote driven markets • Screen based markets • Continuous auction markets • Brokered markets • Hybrid markets • (combination of order- and quote –driven protocols: SETS, 1997, London

  5. The microstructure of financial markets Financial market equilibrium: • Market prices roles: Transmitting Information and allocating scarce resources • Financial Market equilibrium with symmetric information • 2. Financial Market equilibrium with asymmetric information • 3. Financial Market equilibrium with asymmetric information and strategic agents

  6. The microstructure of financial markets Batch Markets with Strategic Informed Traders: • Adverse selection costs of the bid-ask spread. • 1. The Kyle model • 2. The Kyle model with multiple insiders

  7. The microstructure of financial markets Dealer Markets: Information-based models • Adverse selection costs of the bid-ask spread. • 1. Models with adverse selection costs: Glosten and Milgrom (1985) • 2. Models with adverse selection costs and different order sizes: • Easley and O’Hara (1987)

  8. The microstructure of financial markets Inventory models • Bid-ask spread and asymmetric information • 1. The Stoll model (1978) • 2. Order driven markets • 3. Dealers and Informed traders

  9. The microstructure of financial markets Empirical models of market microstructure • Bid-ask spread and order-processing costs • 1. Estimating the bid-ask spread from transaction prices • 2. Price effects of trading • 3. The probabilityofinformed trading • 3. Empirical inventory models

  10. The microstructure of financial markets Liquidity and asset pricing • Transaction costs and asset prices • 1. Transaction costs and expected prices • 2. Liquidity Risk and Asset prices

  11. The microstructure of financial markets Models of the limit order book • 1. Glosten (1994) and the discriminatory pricing rule • 2. The model for an LOB with endogenous choice between limit and market orders • theparlourmodel (Parlour, 1988) • thewinner’scourse problem (Foucault, 1999) • the LOB as a market for immediacy (Foucault et al. , 2005)

  12. The microstructure of financial markets Price discovery • 1. Price effects of trading (the Hasbrouck model (1988)) • 2. A generailized model for prices and trades; ( a VAR Model; Hasbrouck, 1991) • 3. The efficient price (Hasbrouck, 1993) • 4. Price discovery in multiple markets (Hasbrouck, 1995)

  13. The microstructure of financial markets Policy Issues in Financial Market structures • 1. Transparency • 2. Concentration of volume and trading • 3. Consolidation and fragmentation

  14. The microstructure of financial markets References: Acharya, V. V. and L.H. Pedersen, 2005, Asset Pricingwithliquidity risk, Journal of Financial Economics, 77, 375-410. Admati, A., 1985, A noisy rational expectation equilibrium for multi-asset securities markets, Econometrica, 53, 629-57. Admati, A. and P. Pfleiderer, 1988, A theory of intraday patterns: volume and price variability, Review of Financial studies, 1, 3-40. Admati, A. and P. Pfleiderer, 1991, Sunshine trading and financial market equilibrium, Review of Financial studies, 4, 443-81. Amihud, Y. and H. Mendelsohn, 1980, Dealership market. Market making with inventory, Journal of Financial Economics, 8, 31-53. Amihud, Y. and H. Mendelsohn, 1987, Trading mechanism and stock returns: an empirical investigation, Journal of Finance, 42, 533-55. Amihud, Y. and H. Mendelsohn, 1986, Asset Pricing and the bid-ask spread, Journal of Financial Economics, 17, 223-49. Amihud, Y., 2002, Iliquidity and stock returns: cross-section and time-series effects, Journal of Financial Markets, 5, 31-56.

  15. The microstructure of financial markets References (cont): Biais, B., 1993, Price formation and equilibrium liquidity in fragmented and centalized markets, Journal of Finance, 48, 157-85. Biais, B., T. Foucault and P. Hillion, 1997, Microstructure des Marchés Financiers. Institutions, Modéles et Test Empiriques, Paris: Presses Universitaires de France. Biais, B., L. Glosten and C. Spatt, 2005, Market microstructure: a survey for microfoundations, empirical results, and policy implications, Journal of Financial markets, 8, 217-64. Biais, B., P. Hillionand C. Spatt, 1995, An empirical analysis of the limit order book and the order flow in the Paris Bourse, Journal of Finance, 50, 1655-89. Biais, B., D. Martimort and J. C. Rochet, 2000, Competing mechanism in a common value environment, Econometrica, 68, 799-837 Bloomfield, R., and M. O’Hara, 1999, Market transparency: whowins and who losses, ReviewofFincial Studies, 12, 5-35. Bloomfield, R., M. O’Hara and G. Saar, 2002, The «make or take» decision in an electronic market: evidence on theevolutionofliquidity, Working paper, Stern School of Business, New York University.

  16. The microstructure of financial markets References (cont.): Boehmer, E., J. Grammig and E. Theissen, 2007, Estimatingtheprobabilityofinformed trading – does trade misclassification matter?, Journal of Financial Markets, 10, 26-47. Boehmer, E., G. Saar and L. Yu, 2005, Lifting the veil: an analysisof pre-trade transparency at the NYSE, Journal of Finance, 60, 783-815. Brennan, M. J. and A. Subrahmanyam, 1996, Market microstructure and asset pricing: on thecompensation for illiquidity in stock returns, Journal of Financial Economics, 41, 441-64. Brown, D.P. and Z.M. Zhang, 1997, Market orders and market efficiency, Journal of Finance, 52, 277-308. Buti, S., 2007, A challenger to the limit order book: the NYSE specialist, Research Report Services, SS, SwediskInstitute for Financial Research, Stockholm. Chakravarty, S. and C. W. Holden, 1995, An integrated modelof market and limit orders, Journal of Financial Intermediation, 4, 213-41. Choi, J. Y., D. Salandro and K. Shastri, 1988, On theestimationofbid-ask spreads: theory and evidence, Journal of Financial and Quantitative Analysis, 23, 219-30

  17. The microstructure of financial markets References (cont.): Chordia, T., R. Roll and A. Subrahmanyam, 2000, Commonality in liquidity, Journal of Financial Economics, 56, 3-28. Chordia, T., R. Roll and A. Subrahmanyam, 2001, Market liquidity and trading activity, Journal of Finance, 52, 501-30. Christie, W. and P. Schultz, 1994, Why do NASDAQ market makers avoid odd-eighth quotes?, Journal of Finance, 49, 1813-40. Christie, W., J. Harris and P Schulz, 1994, Why did NASDAQ market makers stop avoiding odd-eighth quotes?, Journal of Finance, 49, 1841-60. Copeland, T. and D. Galai, 1983, Information effects on thebid-ask spread, Journal of Finance, 38, 1457-69.

  18. The microstructure of financial markets References (cont): Danthine, J. P. and S. Moresi, 1998, Front-running by mutual fund managers: a mixed bag, European Finance Review, 2, 29-56. De Jong, F., 2002, Measuresofcontribution to price discovery: a comparison, Journal of Financial Markets, 5, 323-8 De Jong, F., T. Nijman and A. Röell, 1995, A comparisonofthecostof trading French shares on the paris Bourse and on Seaqinternational, European EconomicReview, 39, 1277-301 De Jong, F. and P. Schotman, 2003, Price discovery in fragmented markets, Discussion Paper 3987, CEPR, London. Duarte, J. and L. Young, 2007, Why is PIN priced, Journal ofFinancial Economics, 70, 223-60. Easley D. and M. O’Hara, 1987, Price, trade and information in securities markets, Journal of Financial Economics, 19, 69-90. EasleyD., S. Hvidkjaer and M. O’Hara, 2002, Is information risk a determinant of asset returns?, Journal of Finance, 57, 2185-221. Easley D., N. Kiefer, M. O’Hara and J. Paperman, 1996, Liquidity, information and infrequentlytraded stocks, Journal of Finance, 51, 1405-436.

  19. The microstructure of financial markets References (cont): Engle, R. F. and C. W. J. Granger, 1987, Co-integration and errorcorrection: representation, estimation and testing, Econometrica, 35, 251-76. Euronext, 2007, Euronext cash market trading manual. Evans, M. D. D. and R. K. Lyons, 2002, Order Flow and Exchange Rate Dynamics, Journal ofPoliticalEconomy, 110, 170-80. Fama, E. 1970, Efficient capital markets: a reviewoftheory and empiricalwork, Journal of Finance, 25, 383-417. Fama, E. and K. R. French, 1993, Common Risk factors in thereturns on stocks and bonds, Journal of Financial Economics, 33, 3-56. Flood, M., R. Huisman, K. G. Koedijk and R. Mahieu, 1999, Quotedisclosure and price discovery in multiple dealerfinancial markets, Reviewoffinancial Studies, 12, 37-59. Foster, M. M. and T. J. George,1992, Anonymity in security markets, Journal of Financial Intermediation, 2, 168-206. Foucault, T., 1999, Order flowcomposition and trading cost in dynamic limit order market, Journal ofFinancial Markets, 2, 99-134. Foucault, T., S. Moinas, and E. Theissen, 2007, Doesanonymity matter in electronic limit order markets?, ReviewofFinancial Studies, 20, 1707-47.

  20. The microstructure of financial markets References (cont): Foucault, T., O. Kadan, and E. Kandel, 2005, Limit order book as a market for liquidity, Reviewof Financial Studies, 4, 1171-217. Garman, M., 1976, Market microstructure, Journal of Financial Economics, 3, 257-75. Glosten, L., 1989, Insider trading liquidity and the role of monopolist specialist, Journal of Business, 52, 211-35. Glosten, L., 1994, Is the electronic open limit order book inevitable, Journal of Finance, 49, 1127-60. Glosten, L. and E. Harris, 1988, Estimating the component of the bid-ask spread, Journal of Financial Economics, 21, 123-42. Glosten, L. and J. Milgrom, 1985, Bid, ask and transaction prices in a specialist market with heterogeneously informed traders, Journal of Financial Economics, 14, 71-100. Goettler, R., C. Parlour, and U. Rajan, 2008, Informed traders and limit order markets, Journal of Financial Economics, forthcoming. Greene, W.H., 2002, Econometric Analysis, 5thedn, New York: Prentice Hall Grossman, S. and J. Stiglitz, 1976, Information and competitive price system, American EconomicReview, Paper and proceedings, 66, 246-53. Grossman, S. and J. Stiglitz, 1980, On theimpossibilityofinformationallyefficient markets, American EconomicReview, 70, 393-408.

  21. The microstructure of financial markets References (cont): Hamilton, J., 1994, Time Series Analysis, Princeton University Press. Hansch, O., N. Naik and S. Viswanathan, 1998, Do inventories matter in dealership markets? Evidence from the London Stock Exchange, Journal of Finance, 53, 1623-55. Harris, L., 2003, Trading and Exchange, Oxford University Press Hasbrouck, J., 1988, Trades, quotes, inventory and information, Journal of Financial Economics, 22, 229-52. Hasbrouck, J., 1991, Measuringtheinformationcontentof stock trades, Journal of Finance, 46, 179-207. Hasbrouck, J., 1993, Assessingthequalityof a security market: a newapproach to transactionscostmeasurement, Reviewof Financial Studies, 6, 191-212. Hasbrouck, J., 1995, One security, many markets: determiningthecontributions to price discovery, Journal of Finance, 50, 1175-99. Hasbrouck, J., 2002, Stalkingthe «efficient price» in market microstructurespecifications: an overview, Journal of Financial Markets, 5, 329-39. Hasbrouck, J., 2006, Trading costs and returns for US equities: estimatingeffectivecosts from daily data, Working paper, Stern School of Business, New York University. Hasbrouck, J. and D. Seppi, 2001, Commonfactors in prices, order flows, and liquidity, Journal ofFinancial Economics, 59, 383-411.

  22. The microstructure of financial markets References (cont): Hasbrouck, J. and G. Sofianos, 1993, The trades of market market-makers: an analysisof NYSE specialists, Journal of Finance, 48, 1565-94. Hasbrouck, J., 2007, Empirical Market Microstructure, Oxford University Press. Hayek, F.A., 1945, The useofknowledge in society, American EconomicReview, 35, 519-30 Helwig, M., 1980, The aggregationofinformation in competitive markets, Journal of EconomicTheory, 22, 477-98. Hendershott, T., 2005, Merger and hybrid market at the NYSE, Equity and Currency Market Microstructure Conference, Oslo. Ho, T. and R. Macris, 1984, Dealerbid-ask quotes and transaction prices: an empiricalstudyofsome AMEX options, Journal of Finance, 39, 23-45. Ho, T. and H. Stoll, 1980, On dealer markets under competition, Journal of Finance, 35, 259-67. Ho, T. and H. Stoll, 1981, Optimal dealerpricing under transactions and returnuncertainty, Journal of Financial Economics, 9, 47-73. Ho, T. and H. Stoll, 1983, The dynamics ofdealermarkets under competition, Journal of Finance, 38, 218-31. Hong, H. and J. Wang, 2000, Trading and returns under periodic trading closures, Journal of Finance, 55, 297-354.

  23. The microstructure of financial markets References (cont): Huang, R. and H. Stoll, 1996, Dealer versus auction markets: a paired comparison of execution costs on NASDAQ and the NYSE, Journal of Financial Economics, 41, 313-57. Huang, R. and H. Stoll, 1997, The components of the bid-ask spread: a general approach, Review of Financial Studies, 12, 61-94. Jain, O. and G. Joh, 1988, The dependency between hourly prices and trading volume, Journal of Financial and Quantitative Analysis, 23, 269-83. Kaniel, R., and H. Liu, 1998, So whatorders do informed traders use?, Journal of Business, 79, 1867-913. Klemperer, P.D. and M.A. Meyer, 1989, Supply functionequlibria in oligopoly under uncertainty, Econometrica, 57, 1243-77. Kumar, P. and D. J. Seppi, 1998, Limit and market orderswithoptimising traders, Working Paper, Bauer College of Business, Universityof Houston. Kyle, A. 1985, Continuous auctions and insider trading, Econometrica, 53, 1315-35 Kyle, A. 1989, Informed speculation with imperfect competition, Review of Economic Studies, 56, 317-56 Lee, C. and M. ready, 1991, Inferring trade direction from intra-day data, Journal of Finance, 46, 733-46.

  24. The microstructure of financial markets References (cont): Lütkepol, H., 1993, Introduction to Multiple Time Series Analysis, 2nd edn, Berlin: Springer. Lyons, R., 1995, Test of microstructure hypotheses in the foreign exchange market, Journal of financial Economics, 39, 1-31. Lyons, R., 2001, The Microstructure Approach to Exchange Rates, Cambridge, Mass.: MIT Press. Madhavan, A., 1992, Consolidation, fragmentation, and the disclosure of trading information, Journal of Financial Intermediation, 3, 579-603. Madhavan, A., 1996, Security prices and and market transparency, Journal of Financial Intermediation, 5, 255-83. Madhavan, A., 2000, Market Microstructure: a survey, Journal of Financial Markets, 3, 205-58. Madhavan, A., D. Porter and D. Weaver, 2005, Should Securities markets be transparent? Journal of Financial Markets, 8, 265-87. Madhavan, A. and S. Smidt, 1991, A Bayesian model of intraday specialist pricing, Journal of Financial Economics, 30, 99-134. Madhavan, A. and S. Smidt, 1993, An anlysis of daily changes in specialist inventories and quotations, Journal of Finance, 48, 1595-628.

  25. The microstructure of financial markets References (cont): Madhavan, A. and G. Sofianos, 1998, An empirical analysis of NYSE specialist trading, Journal of Financial Economics, 48, 189-210. Manaster, S. and C.S. Mann, 1996, Life in thepit: competitive market making and inventorycontrol, Reviewoffinancial Studies, 9, 953-75. Naik, N. and P. Yadav, 2003, Do dealerfirmsmanageinventory on a stock-by-stock or a portfolio basis? Journal offinancialEconomics, 69, 325-53. NASDAQ Stock market, 2006, NASDAQ Cross. A truly innovative single-pricedopen/close, www.nasdaqtrader.com/trader/openclose/openclose.stm O’Hara, M., 1995, Market Microstructure Theory, Oxford, Blackwell. Parlour, C., 1998, Price dynamics in limit order markets, Reviewof Financial Studies, 11, 789-816. Parlour, C. and D. Seppi, 1993, Liquiditybasedcompetition for order flow, Reviewof Financial Studies, 16, 301-43. Pastor, L. and R. F. Stambaugh, 2003, Liquidity Risk and expected stock returns, Journal of PoliticalEconomy, 111, 642-85. Perotti, P. and B. Rindi, 2006, Market for Information and identitydisclosure in an experimentalopen limit order book, Economic Notes, 1, 95-116. Piqueira, N. S., 2004, stock returns, illiquiditycost and excessive trading activity, unpublishedmanuscript, Princeton university.

  26. The microstructure of financial markets References (cont): Reis, P. and I. Werner, 1998, Does risk sharingmotivateinter.dealer trading, Journal of Finance, 53, 1657-704. Rindi, B. 1994, Sunshine trading revisited: a modelwithstrategicliquidity traders, Working Paper 94.10, UniversityofVenice. Rindi, B. 2008, Informed traders as liquidityproviders: anonymity, liquidity and price formation, Reviewof Finance, 12, 497-532. Roll, R., 1984, A simple implicitmeasureofthebid-ask spread in an efficient market, Journal of Finance, 39, 1127-39. Rosu, I., 2004, A dynamicmodelofthe limit order book, Working Paper, Massachusetts Instituteof Technology. Röell, A., 1990, Dual capacity trading and thequalityofthe market, Journal offinancial Intermediation, 1, 105-24. Sadka, R., 2006, Momentum and post-earnings-announcements drift anomalies: therole ofliquidity risk, Journal of Financial Economics, 80, 309-49. Scalia, A. and V. Vacca, 1999, Does market transperency matter? A case study, Working Paper 359, Research Department, Bank ofItaly. Seppi, D., 1990, Equilibrium block trading and asymmetricinformation, Journal of Finance, , 45, 73-94. Seppi, D., 1992, Block trading and informationrevelationaroundquarterlyearning announcements, ReviewofFinanial Studies, 5, 281-305.

  27. The microstructure of financial markets References (cont): Seppi, D., 1997, Liquidityprovuisionswithh limit orders and strategicspecialists, Review ofFinanial Studies, 10, 103-50. Snell, A. and I. Tonks, 1998, Testing for asymmetricinformation and inventorycontrol effects in market maker behaviour on the London stock Exchange, Journal ofEmpirical Finance, 5, 1-25. Spiegel, M., and A subrahmanyam, 1992, Informedspeculation and hedging in a noncompetitive securities market, Reviewof Financial Studies, 5, 307-29. Stock, J. and M. W. Watson, 1988, Testing for common trends, Journal ofthe American Statistical Association, 83, 1097-107. Stoll, H., 1978, The supplyofdealer services in securities markets, Journal of Finance, 33, 1133-51. Stoll, H., 2000, Friction, Journal of Finance, 55, 1479-1514. Subrahmanyam, A., 1991, Risk aversion, market liquidity and price efficiency, Reviewof Financial Studies, 4, 417-41. Subrahmanyam, A., 2008, Lagged order flows and returns: a longer-term perspective, QuarterlyReviewofEconomics and Finance, 48, 623-40. Viswanathan, S. and J. Wang, 2002, Market architecture: limit order books versus dealership markets, Journal of Financial Markets, 5, 127-67. Wood, R. T. McInish and J. Ord, 1985, An investigationoftransaction data for NYSE Stocks, Journal of Finance, 40, 723-39

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