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Market Microstructure

Market Microstructure. -Why do prices rise? - Because there are more buyers than sellers!. Plan. Why is the organization of trading process important for investors? Buying and selling Short sales Margin and leverage effect Classification of financial markets Primary vs secondary markets

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Market Microstructure

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  1. Market Microstructure -Why do prices rise? - Because there are more buyers than sellers!

  2. Plan Why is the organization of trading process important for investors? • Buying and selling • Short sales • Margin and leverage effect • Classification of financial markets • Primary vs secondary markets • Exchange vs OTC markets FF 2005/06

  3. Examples • Ticks • 1/8 vs 1/32 vs decimal • Price over 100 • Stock splits • Analyst recommendations • Conflict of interests • Failure of LTCM FF 2005/06

  4. Market participants • Brokers • Trading on behalf of a client • Dealers • Trading for their own account • Market-makers • Providing bid-ask quotes FF 2005/06

  5. Placing an order • Market • Limit • Short sale • ‘Selling a cow, which you don’t own’ • Borrow a stock from (another client of) your broker • Stop loss/buy • Conditional market order: to lock in gains FF 2005/06

  6. Margin trading • Initial / maintenance margin • % of MV(assets) kept in the account as collateral • The rest is borrowed from the broker • Margin call • If the amount in the account drops below maintenance margin • Leverage effect: r = (ΔP - interest) / (P0margin) FF 2005/06

  7. Classification of financial markets • Bank credits • Commercial vs Interbank • Foreign exchange (FX) • Spot / forward exchange • Deposit-loan • National markets • Euro markets FF 2005/06

  8. Classification of financial markets (2) • Security market • Primary • Secondary • Exchange: • NYSE, LSE (stocks) • CBOT, LIFFE (derivatives) • OTC (over-the-counter) • NASDAQ FF 2005/06

  9. Desirable characteristics • Informational transparency • Min transaction costs • Liquidity • Ability to open or close large positions without strong effect on prices • Tightness / depth / resiliency • Informational efficiency • Speed of incorporating information to prices FF 2005/06

  10. Market architecture • Degree of continuity • Periodic vs continuous systems • Reliance on market makers • Auction / order-driven market • Dealer / quote-driven market: market maker takes the opposite side of every transaction • Degree of automation • Floor vs screen-based electronic systems FF 2005/06

  11. Market architecture(2) • Protocols • Choice of minimum tick • Rules to halt trading, circuit breakers • Transparency: providing info before (quotes, depths) and after (actual prices, volumes) trades • Extent of dissemination: brokers, customers, or public • Speed of dissemination: real time / delayed feed • Degree of anonymity: hidden orders, counterparty disclosure • Permitting off-exchange / upstairs trading FF 2005/06

  12. Basic trading systems • Batch auction / call market: NYSE open • Agents submit demands to the auctioneer who sets common market clearing price • Continuous auction: NYSE intraday, Euronext • Floor: brokers trade with each other on behalf of their clients • Electronic: the system displays the best limit orders and automatically executes incoming market orders • Dealership market: NASDAQ • Market-makers provide bid and ask prices at which other agents may trade FF 2005/06

  13. Stock exchange vs OTC FF 2005/06

  14. NYSE vs NASDAQ FF 2005/06

  15. Recent developments • Trading online • Exchange-traded funds (ETFs) • Mimick indices • E.g., Cubes, Spiders, Diamonds • Electronic Communication Networks (ECNs) • Automated systems for disclosing / executing trades • Program trading FF 2005/06

  16. Structural shifts • Technological innovations • Substantial increase in trading volume • Competition between exchanges and ECNs • Proliferation of new financial instruments FF 2005/06

  17. Regulation of stock trading • Circuit breakers • Restrictions on trading if prices reach a threshold • Legislation • Firms: public disclosure of relevant info • Employees: no insider trading • Market participants: fair trading • Monitoring by SEC • Key divisions: CorpFin, MktRegulation, Enforcement FF 2005/06

  18. Market microstructure models • Price formation / discovery • How prices impound info over time • Determinants of trading costs • Market structure and design • Trading process vs price formation FF 2005/06

  19. Market microstructure models(2) • Transparency • Info and disclosure • Interaction with other areas in finance • CorpFin: IPO underpricing, stock splits • Asset Pricing: liquidity as risk factor, anomalies vs trading costs • IntlFin: ADRs, cross-border flows FF 2005/06

  20. Selected issues • What are the components of the bid-ask spread? • Risk aversion • Inventory control • Info asymmetry • Why is trading concentrated at the opening and closing? • Optimal choice of timing the transaction by uninformed FF 2005/06

  21. Selected issues(2) • Is continuous bilateral system better than periodic multilateral one? • Is it good for a stock to be traded in several markets? • Gravitation vs stratification • Should the limit order book be displayed in public? • How to execute block trades optimally? FF 2005/06

  22. Conclusions You make more selling information than following it

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