1. Introduction to financial markets - Trading Instruments - Traders - Orders - Organizational structures Harris (2002), Hasbrouck (2007)

1. Introduction to financial markets Trading instruments Securities, contracts, commodities, and currencies. Real assets Commodities, real estate, machines, intellectual properties (patents, art). Financial assets Instruments that represent ownership of real assets and the cash flows that they produce: stocks, bonds, currencies. Derivative contracts: options, futures, forwards, swaps.

1. Introduction to financial markets 1.1 Traders 1.1.1 Proprietary traders 1.1.1.1 Profit-motivated traders: - informed traders - technical traders - dealers also: - rational investors - value investors - arbitrageurs 1.1.1.2 Utilitarian traders - hedgers - liquidity traders - noise traders

1. Introduction to financial markets 1.1.2 Brokers (agencies) - matching clients’ buy and sell orders - connecting to markets - settlement: delivery of traded assets - clearing: reporting, credit management, tax handling, etc. - providing market data - providing research - offering credit Buy-side vs Sell-side Sell-side + brokerage => broker/dealer

1. Introduction to financial markets 1.2 Orders 1.2.1Main definitions: - instrument - quantity (size/amount) - market side (buy/sell) - price: market orders vs limit orders - bid/ask (offer) reservation prices - best bid/ask prices => bid/ask spread - inside/outside market = inside/outside the spread - mid-price - limit order book (LOB) - marketable limit orders (who needs them?)

Example of LOB

1. Introduction to financial markets 1.2.2 Conditional order types: - good-till-cancelled - market-on-open (-close) - stop-orders - fill-or-kill - all-or-none 1.2.3 Short selling short sell => buy to cover up-tick rule

1. Introduction to financial markets 1.2.4 Special orders: - Pegged orders primary - pegged to the best price on the same market side market – pegged to the best price on the opposite market side mid-price – pegged to the best bid/ask mid-price - Cancel & Replace – changes the order size but retains position in LOB - Hidden orders – hidden part has a lower priority but retains position in LOB

1. Introduction to financial markets 1.4 Bid/ask spread Quoted spread: SQ = Effective spread: SE = Mt = 0.5(At + Bt), qt =1 (-1) for buy (sell) orders Pt – transaction price Realized spread: SR =

1. Introduction to financial markets 1.5 Liquidity - breadth - depth - resiliency Amihud (2002): ILLIQ = rk and Vk are return and volume at time k.

1. Introduction to financial markets 1.6 Market structures: Big picture Exchanges (bourses) – highly regulated markets Initial public offering (IPO) is listed on some exchange. After IPO, the issuer sells this security to investors in a primary market. Subsequent trading of securities among investors other than the issuer is conducted in the secondary market (or aftermarket). Trading of exchange-listed securities in an OTC markets is referred to the third market. Alternative to exchanges: over-the-counter (OTC) markets

1. Introduction to financial markets 1.6 Market structures: Big picture (continued) US regulators: Securities and Exchanges Commission (SEC) – stocks & bonds Commodity Futures Trading Commission (CFTC) – commodities Self-regulatorary organizations for brokers and dealers: Financial Industry Regulatory Authority (FINRA) National Futures Association (NFA) Also Financial Accounting Standard Board (FASB)

1. Introduction to financial markets 1.6 Market structures: Big picture (continued) Market structure: execution system + trading session type Execution systems: order-driven markets & quote-driven markets Order-driven market sessions: continuous markets & call markets Most order-driven markets are auctions in which price discovery (market clearing) results in that trading occurs at a highest price that a buyer is willing to pay and at a lowest price that a seller is willing to sell at.

1. Introduction to financial markets 1.6 Market structures: Big picture (continued) Crossing networks (dark pools): derivative pricing rule Pros: - confidentiality - no price impact Contras: - low fill ratio - deteriorating price discovery (“trade at” rule)

1. Introduction to financial markets 1.7 Continuous order-driven markets Limit orders that are not matched upon arrival are entered into the LOB according to the price-time priorities. Price priority has the primary precedence. Size precedence – rarely used. Matching: ‘First In, First Out’ (FIFO) principle. Example: A market buy order of size <= 200 will be filled at the price of 10.30. If the size of the market buy order equals 200, it completely matches A1 and the bid/ask spread jumps from 0.05 to 0.1. Order Price Size Ask2 10.35 200 Ask1 10.30 Bid1 10.25 100 Bid2 10.23

1. Introduction to financial markets 1.8 Call auctions (rules) Call auctions are conducted several times a day (fixings) or at the openings and closings of continuous sessions. Orders submitted for a given call are batched and executed simultaneously at the same price. Prior to auction, all submitted orders are placed according to the price-time precedence rules. Aggregated demand and supply are calculated implying that a trader willing to buy/sell at price P will also buy/sell at a price lower/higher than P. The auction price is defined in such a way that yields a maximum aggregated size of matched orders. In case the rule of maximum aggregated size of matched orders does not yield a unique price, the auction price is chosen to satisfy the rule of minimum order imbalance (i.e. the minimum number of unmatched orders). If even the latter rule does not define a single price, the auction price is chosen to be the closest to the previous auction price.

1. Introduction to financial markets 1.8 Call auctions (example) Pre-auction order book

1. Introduction to financial markets 1.8 Call auctions (example continued) Price discovery

1. Introduction to financial markets 1.9 Oral (open-outcry) auctions Traders (brokers and dealers) gather in the same place (floor market). Traders are required to communicate (using shouting and hand signals) their trading intentions and results of trading to all market participants. In oral auctions, order precedence rules and price discovery are similar to those in continuous order-driven markets. However, there may be some additional secondary precedence rules. In particular, public traders have priority in respect to floor traders.

1. Introduction to financial markets 1.10 Quote-driven markets and hybrid markets In the quote-driven markets, only dealers submit maker orders. All other traders can submit only market orders. Price discovery in these markets means that market makers must choose such bid and ask prices that will cover their expenses and balance buy and sell order flows. Some markets combine quote-driven and order-driven systems in their structure. NYSE and NASDAQ are examples of such hybrid markets.