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

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

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

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

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

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

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

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

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

10. 10 Limit order book: example

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

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

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

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

15. 15 Hybrid trading structures n 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. 16 Recent developments n General tendency towards hybrid systems and separation by order size –limit order system for small trades –quote driven systems for large trades n Motivated by –competition between exchanges –execution costs –overview: Demarchi and Foucault (1998)

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

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

19. 19 Quality of markets (3) n 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. 20 Quality of markets (4) n Regulation of prices –priority rules (price/time) –tick size –circuit breakers

21. 21 C:Market microstructure n 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. 22 Price formation n Traditional view of price formation on financial markets: “invisible hand” or Walrasian auctioneer –equates supply and demand at equilibrium price n In practice, price formation more complex –traders don’t arrive simultaneously –asymmetries of information n Induces costs of trading

23. 23 Microstructure Theory n Inventory models –market makers provide “immediacy” –bid-ask spread compensates market maker for price risk on inventory n 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. 24 Empirical research n Estimates of transaction costs and liquidity –components of the bid ask spread –role of inventory control –price impact of trades n Price discovery process –information is incomplete –how and how fast is private information reflected in market prices?

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

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