Caput Financial Markets

1. Caput Financial Markets Frank de Jong Universiteit van Amsterdam September 2001

2. Role of financial markets • Financial markets match supply and demand of financial assets • stocks, bonds, commodities, derivatives • Financial markets are among the most liquid of all markets • Despite this, there are transaction costs! • Market microstructure research tries to explain this

3. A: Organization of financial markets B: Quality of markets C: Market microstructure research D: Course setup Overview

4. A: Organization of financial markets • Periodic vs. continuous trading • Price driven vs. order driven • Other aspects • centralization • transparency • regulation

5. Periodic vs continuous trading • Periodic trading: batch auctions • often used for initial offerings of stocks and bonds • also for secondary markets with low turnover • Continuous trading • for secondary markets with high turnover, like equity markets (e.g. AEX), foreign exchange

6. Periodic vs continuous trading • Some continuous markets start or close trading sessions with a batch auction • Amsterdam, Paris, NYSE

7. Price / quote driven markets • Limited number of professional market makers provide bid and ask quotes • buy and sell prices • Other participants trade with market makers • Quotes may be firm or indicative • Market makers trade for own account

8. Price driven markets • Examples • London Stock Exchange • NASDAQ • foreign exchange market • bond market

9. Order driven markets • Limit order market: liquidity is provided by public limit order book • continuous double auction • trading is against these limit orders • Examples: • Euronext, Xetra (Frankfurt)

10. Limit order book: example

11. LOB example • best bid-ask spread: 101-99 = 2 • depth at best bid and ask: (100,500)

12. Limit order book: after 200 share sale @ 99

13. LOB: example after 200 sale • best bid-ask spread: 101-98=3 • depth at best bid-ask: (200,500) • spread increased (always) • depth also increased (coincidence)

14. Order driven markets (2) • Open outcry markets • trading on orders provided by trading crowd • often used in futures and option markets

15. Hybrid trading structures • Pure price and order driven markets are rare, most exchanges are mix of both • NYSE has one specialist for each stock, competes with public limit orders • AEX used to have similar system (hoekman) • London Stock Exchange and NASDAQ recently introduced limit orders that compete with market makers

16. Recent developments • General tendency towards hybrid systems and separation by order size • limit order system for small trades • quote driven systems for large trades • Motivated by • competition between exchanges • execution costs • overview: Demarchi and Foucault (1998)

17. B: Quality of markets • Execution costs • explicit costs: fees, taxes • implicit cost: bid-ask spread • Liquidity • price impact of trade • risk of non-execution • resiliency (speed of price recovery) • Price efficiency

18. Quality of markets (2) • Transparency • large differences in pre-trade and post trade transparency among markets • e.g. Paris Bourse very transparent, foreign exchange market not at all • Privileges for specialist • NYSE: only specialist knows limit order book and may “stop” orders

19. Quality of markets (3) • Fragmentation of order flow • off exchange trading • “upstairs” block trades • electronic communication networks (ECN) • dual or multiple listings • American Depository Receipts (ADR) • SEAQ International • mergers of exchanges

20. Quality of markets (4) • Regulation of prices • priority rules (price/time) • tick size • circuit breakers

21. C: Market microstructure • O’Hara (1995): Market microstructure is the study of the process and outcomes of ex-changing assets under explicit trading rules • microstructure literature analyzes how specific trading mechanisms affect the price formation process • contrasts with usual “black box” view of price determination

22. Price formation • Traditional view of price formation on financial markets: “invisible hand” or Walrasian auctioneer • equates supply and demand at equilibrium price • In practice, price formation more complex • traders don’t arrive simultaneously • asymmetries of information • Induces costs of trading

23. Microstructure Theory • Inventory models • market makers provide “immediacy” • bid-ask spread compensates market maker for price risk on inventory • Information based models • informed versus uninformed traders • market makers set spread to compensate for adverse selection costs • buyer initiated transaction gives signal that price is too low; adjust price upward

24. Empirical research • Estimates of transaction costs and liquidity • components of the bid ask spread • role of inventory control • price impact of trades • Price discovery process • information is incomplete • how and how fast is private information reflected in market prices?

25. Further topics • Other financial markets • foreign exchange: decentralized structure • derivatives • price determined by underlying asset • heterogeneous products • Experimental research

26. D: Course setup • Week 1: Introduction • Week 2-5: Theory • Midterm assignment or exam • Week 6-10: Empirical & topics • Final essay