Lecture Notes in Market Microstructure and Trading

The following sections are included:

• PREFACE
• AUTHOR’S NOTE
• CONTENTS

The aims of this lecture are:

This lecture puts the topic of trading in securities markets into a bigger context of financial economics and relates the current topic to what we know about capital markets, asset pricing and behavioral finance…

Summary of Lecture 1

This lecture defines terms and concepts necessary to pursue studies of securities market trading and market microstructure.

After this lecture, the student will be able to take part in discussions of trading problems and start developing their own analytical skills for solving such problems.

The student will also be equipped with the terminology necessary for further reading of research articles in the area.

The lecture notes in this section are based on Teall [2012, Chapter 1], which is also recommended as further reading for this section.

Summary of Lecture 2

These lecture notes introduce the reader to institutions, and describes their importance and market impact.

For further reading see Teall [2012, Chapter 3].

Summary of Lecture 3

This lecture provides a detailed definition of transaction (trade execution) costs and how they are measured.

The focus is on costs of trading rather than investment return performance. This is emphasized in a discussion contrasting measures of investment performance with measures of transaction costs.

Understanding Volume Weighted Average Price (VWAP) and Implementation Shortfall (IS) are core aims of this section. When we calculate IS we focus on Commissions, Market Impact vs. midpoint on order arrival and Opportunity Cost vs. midpoint price on order arrival. We ignore delay costs (used in some applications) as these can be subjective and sufficient information is not always available.

Exercises in how to compute transaction costs with solutions are provided at the end of the lecture.

Summary of Lecture 4

This lecture continues to go deeper into how the trading process is organized in modern market, we cover exchange, alternative trading systems (ATSs) and how market fragmentation and new trading technology has impacted markets. For markets to be efficient, fair and provide the functions they are set up to fulfill, regulation is an important aspect. We discuss regulation from a broad international perspective.

Summary of Lecture 5

• Information and Trading
• Noise Traders
• Adverse Selection and the Spread

Summary of Lecture 6

• Rational Investor Paradigms
• Prospect Theory
• Behavioral Finance
• Neurofinance: Getting into the Investor’s Head
• The Consensus Opinion: Stupid Investors, Smart Markets?

The following sections are included:

• A. Market Efficiency and Random Walks
• B. Risk
• C. Arbitrage
• D. Limits to Arbitrage

The following sections are included:

• Arbitrage
• Does Pure Arbitrage Exist?
• Pairs Trading and Stat-Arb
• Recap of Teall Chapter 6 — Limits to Arbitrage
• Derivative Securities Markets and Hedging
• Put-Call Parity
• Options and Hedging in a Binomial Environment
• Valuing the One-Period Option — Extending the Binomial Model to Two Periods
• Two Time Periods — Extending the Binomial Model to n Time Periods Illustration: Three Time Periods
• Convergence of the Binomial Model to the Black–Scholes Model
• The Greeks and Hedging in a Black–Scholes Environment
• Delta Neutral Hedging
• Example Real Option Prices
• Example Real Option Prices
• Recap Chapter 6: Implied Volatilities

Introduction to Market Efficiency

• An Efficient Capital Market is a market where security prices reflect all available information.
• In an efficient market, the expected price of a tradable asset, given the information φ available to the market and the information φk available to any investor k, equals the expected price based on the information available to the market for all investors k:
• The price of the asset reflects the consensus evaluation of the market based on the information available to the market, regardless of private information held by investor k.
• Individual k's information set φk does not improve his estimate of expected price in an efficient market; the market price already reflects all relevant information φ including investor k's special information φk.
• In a perfectly efficient market where security prices fully reflect all available information, all security transactions will have zero net present value.

The following sections are included:

• A. Illegal Insider Trading
• B. Front Running and Late Trading
• C. Bluffing, Spoofing and Market Manipulation
• D. Rogue Trading and Rogue Traders
• E. Trading and Ponzi Schemes

The following sections are included:

• Regulation + Revision
• Regulatory Bodies
• Why should markets be regulated?
• Mandate for the Regulators
• But how can we evaluate “fair” and “efficient”?
• Measuring Efficiency
• Measuring “Fair”
• Data Requirements for Regulation
• Recent Regulatory Responses
• Final Exam Structure
• Section 1
• Section 2a — Facilitation
• Section 2b — Trading
• Section 2c — Data
• Section 3a — Manipulative Trading
• Section 3b — Regulation
• Section 4a — Dark Pools + Transaction Costs
• Section 4b — Dark Pools
• Section 5 — Market Innovations

Advanced Market Microstructure

• 1. Trading Stories Harris Chapter 2
• 2. Hasbrouck Chapters 1 and 2 Introduction and Trading Mechanisms
• 3. Connecting to Corporate Finance: Insider Trading: Regulation and Empirical Research
• 4. Discussing a Research Paper

The following sections are included:

• Order driven markets — Introduction
• The Uniform-Pricing Rule and Single-Price Auctions
• The Discriminatory-Pricing Rule and Continuous Two-Sided Auctions
• The Derivative Pricing Rule and Crossing Networks
• Summary and Points to Remember
• GPR(2005) Discussion Paper Limit Order Books
• GPR(2005) Methodology and Model
• GPR(2005) Simulation of model
• GPR(2005) Results
• Future Research Stemming from GPR(2005)
• Pagano and Roell (1996)
• The continuous auction, harder to analyze pp. 590–591
• Endogenous insider trading without pre-commitment to a strategy: The case of different trade sizes (large and small) — Future Research from Pagano and Roell (1996)

The following sections are included:

• Liquidity Suppliers: Dealers, Market Makers and Their Inventories
• Dealers
• Additional Material
• Two Important Exchanges
• Why Market Makers
• DMM (Former Specialists)
• Responsibilities
• The Future
• Risk Exposure for Dealer

The following sections are included:

• Assignment
• Liquidity
• Immediacy: Example: Best Execution Performance of an Online Broker
• An Event Study of a Liquidity Changing Event
• Event Study Methodology
• Difference in Difference DID Methodology
• Points to Remember
• Volatility
• Forecasting Volatility: GARCH (1,1)
• Points to Remember
• Reading Article
• Transparency
• Reading Article (1)
• Reading Article (2)
• Methodology
• Implications — Reading Article (3)
• Additional Reading (3) Also on BB
• The Correct Way to Calculate Spreads

The following sections are included:

• Assignment
• Models
• The Glosten–Milgrom (1985) Model
• The Kyle (1985) Model
• Recent Work