Contents 7
Figures 8
Tables 9
Preface 11
Introduction 13
Outline of the book 15
References 17
1 Institutions and market structure 19
1.1 Trading protocol 19
1.1.1 Order-driven markets 19
1.1.2 Quote-driven markets 24
1.1.3 Hybrid markets 24
1.1.4 Transparency 26
1.2 Market structure 27
1.2.1 Market structures around the world 27
1.2.2 The market structure of the NYSE 29
1.2.3 The Hybrid Market model 31
1.3 Orders and order properties 33
Example 1: Batch opening and closing auction 34
Example 2: Limit order book (LOB) 39
Example 3: LOB and excess volatility price ranges 40
References 42
2 Financial market equilibrium 44
2.1 Introduction 45
2.1.1 Allocating scarce resources 45
2.1.2 Transmitting information 46
2.2 Financial market equilibrium with symmetric information 48
2.2.1 A single risky asset 48
2.2.2 Multiple risky assets and the CAPM 49
2.3 Financial market equilibrium with asymmetric information 50
2.3.1 Na茂ve expectations 53
2.3.2 Rational expectations 53
2.4 Financial market equilibrium with asymmetric information and strategic agents 59
Exercise 61
Exercise 1 61
References 63
3 Batch markets with strategic informed traders 64
3.1 Introduction 64
3.2 The Kyle model 65
3.2.1 One insider and a perfect signal 65
3.2.2 Noisy signal 70
3.3 The Kyle model with multiple insiders 72
3.3.1 Perfect signals 72
3.3.2 Noisy signals 73
3.3.3 Fixed entry costs 77
3.3.4 Heterogeneous signals 78
Exercise 79
Exercise 1 79
References 80
4 Dealer markets: information-based models 81
4.1 A model with adverse selection costs 81
4.1.1 The equilibrium prices 82
4.2 Extension: different order sizes 85
4.2.1 Equilibrium 86
Exercises 89
Exercise 1 89
Exercise 2 90
Exercise 3 91
Exercise 4 91
References 91
5 Inventory models 92
5.1 The Stoll model 93
5.1.1 Pricing with initial inventory 95
5.2 Order-driven markets 95
5.2.1 Competitive dealers 96
5.2.2 Imperfect competition 97
5.3 Dealers and informed traders 99
Exercises 100
Exercise 1 100
Exercise 2 101
References 101
6 Empirical models of market microstructure 103
6.1 Definitions of transaction costs 103
6.2 Estimating the bid\u2013ask spread from transaction prices 108
6.2.1 Roll\u2019s model 108
6.2.2 Extensions of Roll\u2019s model 111
6.3 Price effects of trading 112
6.3.1 The Glosten and Harris model 112
6.4 The probability of informed trading 116
6.4.1 Intraday data 116
6.4.2 Inferring trade direction 116
6.4.3 The PIN model 117
6.4.4 Maximum likelihood estimation of PIN 118
6.5 Empirical inventory models 119
6.5.1 The Ho and Stoll model 119
6.5.2 Transaction cost estimation with inventory costs 120
6.5.3 Transaction cost estimation with adverse selection and inventory costs 120
6.5.4 Other empirical evidence on inventory control 121
Exercises 122
Exercise 1. Roll\u2019s estimator 122
Exercise 2. Asymmetric information and Roll\u2019s estimator 123
Exercise 3. Empirical exercise 125
References 126
7 Liquidity and asset pricing 128
7.1 Transaction costs and expected returns 128
7.1.1 A formal model 128
7.1.2 Empirical evidence 130
7.2 Liquidity risk and asset prices 132
7.2.1 Liquidity risk factor models 133
7.2.2 The liquidity CAPM 134
Exercises 136
Exercise 1 136
Exercise 2 137
References 137
8 Models of the limit order book 139
8.1 Glosten (1994) and the discriminatory pricing rule 139
8.1.1 The model for an LOB with risk-averse imperfectly competitive dealers 143
8.2 The model for an LOB with endogenous choice between limit 145
and market orders 145
8.2.1 The Parlour model 147
8.2.2 The winner\u2019s curse problem 152
8.2.3 The LOB as a market for immediacy 158
Exercises 164
Exercise 1 164
Exercise 2 164
Time T: 165
Time T鈭?: 165
Exercise 3 166
Exercise 4 166
Exercise 5 168
References 169
9 Price discovery 171
9.1 Price effects of trading 171
9.1.1 Hasbrouck\u2019s model 172
9.1.2 A reduced-form approach 173
9.2 A generalized model for prices and trades 174
9.3 The efficient price 176
9.3.1 Inferring the efficient price 177
9.3.2 Structural models 178
9.3.3 Prices and trades 180
9.4 Price discovery in multiple markets 181
9.4.1 Two markets 181
9.4.2 N markets 182
Appendix: Lag polynomials 185
Exercises 186
Exercise 1 186
Exercise 2 187
Exercise 3 187
Exercise 4 188
Exercise 5 188
References 191
10 Policy issues in financial market structure 192
10.1 Transparency 192
10.1.1 Transparency with strategic informed agents 193
10.1.2 Dual trading 196
10.1.3 Identity disclosure and rational liquidity provision 198
10.2 Concentration of volume and volatility 201
10.3 Consolidation and fragmentation 203
References 207
Index 209