Chapter 5: Market Microstructure

Introduction

1. What is the microstructure of

markets
2. Liquidity
3. Transparency
1. The microstructure of markets
• Market microstructure examines the trading mechanisms for securities.
• “Market microstructure is the area of finance that studies the process by which investors’ latent demands
are ultimately translated into prices and volumes.” Madhavan (2000)
• Various interesting market issues:
The reasons for trade:
• Trading involves the exchange of cash for an asset with unknown value.
• Market participants have different beliefs and expectations about the future value of the asset(Private Value)
• Private value may be different from the cash equivalent that can be exchanged for the asset, which motivates
trading behavior.
The protocol for trading:
• Market microstructure models are normally very specific about the ‘rules of the game’ for trading financial
securities
Many prices:
• The classical capital market theory, such as the efficient market hypothesis, deals with the single equilibrium
price and equilibrium quantity.
• In market microstructure models there is normally no such price – instead, there are many prices depending
on whether you wish to buy or sell the asset, how much you wish to trade, etc.
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2. Liquidity
• Market liquidity refers to the ease with which an asset can be bought or sold without
causing a significant impact on its price.
• Two important aspects: elasticity and trading costs.
1. Elasticity: the responsiveness of prices to changes in trading volume(quantity shocks)
• In infinitely elastic markets (which is at the liquid extreme) there is no price impact following quantity
shocks
• In infinitely inelastic markets (which is at the illiquid extreme) all impact of quantity shocks is captured
by price changes.
2. Trading costs:
• Direct costs: broker commission, stamp duty, etc
• Indirect costs: the difference in price depending on whether you want to buy or sell the asset(bid-ask
spread)
• Even ignoring the direct trading costs, if you buy a certain quantity of the stock and then sell
immediately, you expect to lose money since typically you buy at a price close to the higher ask price
and sell at a price close to the lower bid price.
• The bid-ask spread is, therefore, also an indirect measure of liquidity.

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3. Transparency
• Transparency in markets refers to the availability of information when submitting an order.
• In the limit order markets, traders can submit limit orders and market orders.
• Market orders are executed quickly if there are matching orders on the opposite side.
• Limit orders may not be immediately executed and are stored in the system.

• Waiting limit orders provide potential liquidity for future orders.

• Data about waiting limit orders serves as important information for traders, helping them
make informed decisions when submitting new orders.

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Limit orders vs Market orders
• Limit buy order: an order that states that the investor is willing to buy any quantity up to
at a price not exceeding -
• Market buy order: an order that states the investor is willing to buy any quantity up to at
any price - – i.e. a limit order with a limit price equal to infinity.
• Limit sell order: an order that states that the investor is willing to sell any quantity up to at
a specified price or better –
• Market buy order: an order that states that the investor is willing to sell any quantity up to
at any price -

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Limit order Markets – collecting and executing these orders
• Example
• Suppose the market has received the following orders at the time it is due to generate an
open price.

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Limit order Markets – collecting and executing these orders

Price

100

+¿
20 100 120 Quantity

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Limit order Markets – collecting and executing these orders

Price

110
100

20 50 80 120 130 Quantity

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Limit order Markets – collecting and executing these orders

Price
• The lines cross at a quantity of 80 and a
price of 100, so the open price will be 100.
• All of the market sell orders will be
executed at the price of 100, and all of the
20 units market buy plus 60 units of the
limit buy will also be executed at the price
of 100.

110
100

20 50 80 120 130 Quantity

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Limit order Markets – collecting and executing these orders
• The limit orders not executed will remain in the system to meet new incoming orders.

40 Ask price

Bid price

• These orders form the bid-ask spread of the market, which is the ask price of 110 and the
bid price of 100.

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Limit order Markets – collecting and executing these orders
• Following the open, new orders are collected and executed according to two priority
rules.
1. Priority is as before on price:
• the buy orders with the highest price and the sell orders with the lowest price have always the
greatest chance of execution.
2. Orders are ordered on submission time:
• the oldest orders (given the same price) have the greatest chance of execution.

• Fully electronic limit order markets have now become a very popular way of organising
trading activity on stock exchanges around the world.

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Market Microstructure Model
• Spread Decomposition Models
• The bid-ask spread consists of at least three components:
• order processing costs (including costs of exchange infrastructure etc.),
• inventory costs (to compensate for the risk of holding a sub-optimal portfolio) and
• adverse selection costs ((to compensate for the risk of losing to a superior informed trader).

• Sequential Trade Models

• Glosten and Milgrom model
• Kyle model

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Bid-ask bounce: the Roll model
• Suppose there exists an informationally efficient price for an asset at a specific time .

or

• The price innovations in are i.i.d.(identically and independently distributed) with zero
mean.

• Now suppose this asset is traded in a competitive market where the dealer incurs a cost
per trade.
• Bid price would be
• Ask price at the ask ,
• .

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Bid-ask bounce: the Roll model
• The transaction price at time can be expressed as:

• where
• if the trade is at the ask
• if the trade is at the bid.

It is generally true for any given period, therefore,

• We shall also assume that buys and sells are equally likely and serially independent.

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Bid-ask bounce: the Roll model
• The variance of price changes can be calculated as:

• Therefore, the variance of the transaction price innovations is:

• Note that we can actually estimate from actual data about the transactions, but then we
cannot recover singularly and .

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Bid-ask bounce: the Roll model
• We need another equation to write down a system of two equations into unknown.
• Let’s turn to the lag one autocovariance of price changes, i.e. the covariance between and

*Note that ; ; all equal to zero.

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Bid-ask bounce: the Roll model
•

• Since both parameters and can be estimated directly we can always find an estimate of
spreads and fundamental price variance which are clean of market microstructure effects.

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Bid-ask bounce: the Roll model
Does the Roll Model work when we bring it to the data?
• From the NYSE, a study from 2003
• the directly estimated Bid-Ask Spread is equal to $0.032.
• If we estimate and from market data and then we calibrate the predicted Bid-Ask Spread which
is equal to 2c, if you remember from before, then we find that this is equal to $0.034 which is
very, very similar to the value that we get from estimating the spread directly.

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Glosten-Milogrom

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Glosten-Milogrom

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Glosten-Milogrom

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Glosten-Milogrom
• 2. The market maker
• The market maker’s problem is to determine bid and ask prices B and A
• , such that the market maker makes zero profit on the transaction. This does not mean the
market maker is going to set the same price as the bid ask price, however. The market
maker thinks it is more likely that somebody is willing to buy the asset at the ask when the
value is high, since an informed trader will never sell when the value is high. The event that
somebody wants to buy at the ask is, therefore, good news and the event that somebody
wants to sell at the bid is bad news, caused by so-called adverse selection. The prior
beliefs of the market maker is that the value is low with probability δ
• and high with probability 1–δ
• , and a bid or an ask transaction leads to revision of the market maker’s beliefs.

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• The revision process is governed by Bayes law:

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Kyle Model

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Kyle Model

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Kyle Model

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Kyle Model

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Kyle Model

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Kyle Model

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Kyle Model

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Kyle Model

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Kyle Model

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Discrete version of the Kyle model
• The original Kyle set-up is somewhat complicated so we illustrate the main idea using a
much simpler, discrete, version in this section.

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Discrete version of the Kyle model

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Why market microstructure matters

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Summary
• This chapter dealt with market microstructure which, broadly speaking, is the process by
which investors’ intention to trade is ultimately transformed into actual transaction volume
and price.
• The chapter had a brief outline of the workings of a limit order market, which is now a
common market structure for exchange-traded instruments such as bonds and equities.
• The Roll, the Glosten-Milgrom and the Kyle models were briefly outlined, and these models
contain most of the relevant concepts that appear in relation to market microstructure.
• There was also a relatively simple discrete outline of the Kyle model to complement the
original set-up, which is somewhat technical.
• Finally, the chapter discussed why market microstructure is relevant for investors.

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Sample examination questions
• Explain why market microstructure matters to investors.
• There is 80% probability of noise traders trading in the market, who buy and sell with 50%
probability each. The rest of the time we expect informed investors to trade, and we
assume these will buy if they have good information about the asset pay-off and sell if they
have bad information. The asset is worth 110 or 90, each equally likely as seen by
uninformed agents, and where the realisation is known perfectly by the informed investors.
Work out the bid-ask spread in the first round of trading in the Glosten-Milgrom framework.
• Demonstrate that assets whose ‘fundamental’ price follows a random walk will nonetheless
contain autocovariance in ‘transaction’ prices, using the Roll model.

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Exercise

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