Trading and Exchange: A Course in Market Microstructure
Prof. Eugene Kandel
New Economic School, Moscow
Fall 2006
Course Description: This course exposes the students to financial markets (with the emphasis on the stock markets) around the world. We will examine various functions of financial markets, such as transfer of resources over time, price discovery, risk sharing, and trade, and identify the institutions that alleviate fundamental problems associated with the provision of these tasks. These problems include information asymmetry among market participants, moral hazard, parasitic behavior, and coordination. Along with overview of several important markets, this course presents the important milestones in the development of the field of Market Microstructure in the last 30 years, with the emphasis on basic concepts and recent work. There will be an extensive discussion of the theory, a short survey of empirical work, and an attempt to present interesting issues left to explore. Given the time constraints, the course is not exhaustive; the interested students should read further.
While the course is emphasizes how financial markets work in the real world, it is also a good first primer for those interested in studying these markets. Sound conceptual and institutional knowledge is imperative to any student who seeks to use or become a player in these markets. At the end of the course, I hope that you will leave with a keen appreciation of the importance of understanding the structure of the market using the economic principles behind them. You will also be able to evaluate current or future regulatory proposals to change the way markets work as well as identify trends that may shape the future of our trading landscape.
Course Structure: The course consists of three modules. In the first module, we will study the roles of financial markets in the context of Finance theory and in reality, and identify factors that may get in the way. We will outline the structure of the financial services industry, and outline the roles played by various institutions.
The second module examines the roles and the structure of the stock market in detail. First, we will discuss how the stock market acts as a primary market for issuers who seek capital. In particular, we will study the various institutional details that govern the IPO process and how they facilitate risk sharing and mitigate information asymmetry in newly created securities. Next, we will study the role of stock market as a secondary market for already issued securities. We will examine possible market structures that are used to trade securities and understand the role played by different participants in the efficient functioning of these markets. We will examine how do various market design features impact their operation.
In the third module, we will examine various characteristics of market quality, and how regulation and market design affect them. In particular, we will focus on transaction costs, volatility, immediacy provision, as well as on cases when the stock market could break down. We will also take a brief look at other markets, such as the market for Treasuries, FX market, and the market for corporate bonds and study institutional features unique to these markets. The extent to which we will cover each of these markets will depend on the time available.
The lectures will have a broad intuitive focus, but I would like the students to read a limited number of papers to understand their logic. Those interested may want to consult two references: Ph.D.-level textbook: Maureen O’Hara, Market Microstructure Theory, Blackwell, 1995. MBA-level textbook: L. Harris, Trading and Exchanges, OxfordUniversity Press, 2003 – I assign chapters from the latter..
Assignments: I expect you to read the required papers before each class, and be ready to discuss them. I suggest reading as many chapters from Harris’s book before the course starts as you can. I will assign a problem set that is due on September 26. The problem set will involve a few analytical questions and a short referee report on a paper of my choice. There will be a short exam in class on September 28. If you had read the required papers, and followed the discussion in class, you will have no difficulty with it. I will also ask you to think about certain issues as we progress – you will not have to turn these in, but I will ask for your opinion in the next class.
Grades will be assigned based on the problem set (30%), the exam (60%), and class discussion-participation (10%).
Feel free to contact me with any questions, requests, etc at .
Module I: The Role of Financial Markets
- Instructor, course, and students introductions.
- Demand for Exchange: benefits from trade. Finance: transfer of resources over time and risk sharing as the drivers of exchange.
- CAPM world: macro view of the markets.
- Closer view on the markets: Financial services (Financial Intermediation) industry: the main players and their roles.
- The role of the secondary market
Required Readings:
Chapters 3, 8 of Trading and Exchanges (please read before coming to the first class).
Module II: Structure of the Stock Market
Stock Market as a Primary Market for Capital
- Possible sources of capital. Why go public?
- Information asymmetry and its effects.
- How it is done: the basic framework; the role of investment banks:
- Underpricing, long run underperformance and their explanations.
- Listing decisions.
Required Readings:
- A Review of IPO Activity, Pricing and Allocations, Jay Ritter and Ivo Welch, Journal: Journal of Finance (August 2002) (
- A Guide to the Initial Public Offering Process, Katrina Ellis, Roni Michaely and Maureen O’Hara, (
- Differences between European and American IPO Markets, Jay Ritter (
Optional Readings:
W.R.Hambrecht’s Open IPO,
Stock Market as a Secondary Market
- Is trading is a zero-sum game?
- Motives for trading
- Types of orders (strategies)
- Design of secondary markets: Dealer, Call auctions, Limit Order Book.
- Market microstructure and asset prices.
Required Readings:
- Trading and Exchanges Chapters 5, 6, 13, 14.
- H. Stoll, 1978, The Supply of Dealer Services in Securities Markets, Journal of Finance, 1133-1151.
- Why do NASDAQ Market Makers Avoid Odd-Eighth Quotes?, William G. Christie; Paul H. Schultz, The Journal of Finance, Vol. 49, No. 5 (Dec., 1994), pp. 1813-1840.
- Effects of Market Reform on the Trading Costs and Depths of Nasdaq Stocks, Michael J. Barclay; William G. Christie; Jeffrey H. Harris; Eugene Kandel; Paul H. Schultz, The Journal of Finance, Vol. 54, No. 1 (Feb., 1999), pp. 1-34.
- US Equity Markets: Overview and Recent History, Joel Hasbrouck, 2004.
Module III: Other Markets, Market Quality, Regulation.
Other Equity Markets: London, Euronext, Tokyo.
Other Markets: FX, Treasuries, Corporate bonds, ETFs, Derivatives.
Measures of Market Quality:
- Liquidity measures.
- Volatility and price discovery.
- Transaction costs:
- Can markets break down?
Regulation.
Summary of the course.
Required Reading
Trading and Exchanges, Chapters 19, 20, 21, 28
Ananth Madhavan, Market Microstructure: A Practitioner’s Guide, ,
Optional reading:
New Electronic Trading Systems in Foreign Exchange Markets, Dagfinn Rime,
A story of a 15 year old stock manipulator:
Suggested Readings for Advanced and Interested Students
1. Overview
H. Demsetz, 1968, The Cost of Transacting, Quarterly Journal of Economics, 33-53.
Ananth Madhavan, 2000, New Developments in Market Microstructure: A Survey, Journal of Financial Markets.
Joel Hasbrouck, 2004, US Equity Markets: Overview and Recent History.
This is an Appendix to his lecture notes available on his website
2. Inventory models
H. Stoll, 1978, The Supply of Dealer Services in Securities Markets, Journal of Finance, 1133-1151.
Ho and Stoll, 1983, The Dynamics of Dealer Markets Under Competition, Journal of Finance, 38, 1053-1074.
A. Yakov, and H. Mendelson, 1980, Dealership markets: Market-making with inventory, Journal of Financial Economics 8, 31-53.
O'Hara and Oldfield, 1986, The Microeconomics of Market Making, Journal of Financial and Quantitative Analyses, December, 361-376.
A. Madhavan and S. Smidt, 1993, An Analysis of Changes in Specialist Inventories and Quotations, Journal of Finance, 48(5).
J. Hasbrouck and G. Sofianos, 1993, The Trades of Market maker: An Empirical Analysis of NYSE Specialist, Journal of Finance, 48(5).
R. Lyons, Tests of microstructural hypotheses in the foreign exchange market, Journal of Financial Economics, 39.
O. Hansch, N. Naik, S. Vishwanathan, 1998, Do inventories matter in dealership market? Evidence from the London Stock Exchange, Journal of Finance, 53(5).
P. Reiss and I. Werner, Does Risk Sharing Motivate Inter-dealer Trading?, Journal of Finance, 53(5).
3. Information and Price Discovery; Adverse Selection;
Hellwig, Martin, 1980, Aggregation of Information in Competitive Markets, Journal of Economic Theory.
Copeland and Galai, 1983, Information effects and the Bid-ask spread, Journal of Finance, 1457-1469.
P. Milgrom and N. Stokey. 1982. Information, trade, and common knowledge, Journal of Economic Theory 26, 17-27
Tirole, Jean, 1982. "On the Possibility of Speculation under Rational Expectations," Econometrica, Econometric Society 50, 1163-81.
Glosten and Milgrom, 1985, Bid, Ask and Transaction Prices in a Specialist market, Journal of Financial Economics, 71-100.
Easley, David, and Maureen O'Hara, 1987, Price, trade size, and information in securities markets, Journal of Financial Economics 19, 69-90.
Easley and O'Hara, 1992, Time and Process of Security Price Adjustment, Journal of Finance, 577-606.
Kandel and Pearson, 1995, Differential Interpretation of Information and Trade in Speculative Markets, Journal of Political Economy, August.
4. Strategic Models of Information Asymmetry
Kyle, 1985, Continuous Auctions and Insider Trading, Econometrica, 1315-1336.
Admati and Pfleiderer, 1988, A Theory of Intraday Patterns; Volume and Price Variability, Review of Financial Studies, 1, 3-40.
Foster and Viswanathan, 1993, Variations in Trading Volume, Return Volatility and Trading Cost, Journal of Finance, 187-211.
5 .Market for Liquidity – endogenous supply and demand.
Cohen, Meier, Schwartz, Whitcomb, 1981, Transaction Cost, Order Placement and Bid-Ask Spread, Journal of Political Economy, 89, 287-305.
Parlour, Christine, 1998, Price dynamics in limit order markets, Review of Financial Studies 11, 789-816.
Foucault, Thierry, 1999, Order Flow Composition and Trading Cost in a Dynamic Limit Order Market, Journal of Financial Markets.
Thierry Foucault, Ohad Kadan and Eugene Kandel, 2005, Limit Orders Book as a Market for Liquidity, Review of Financial Studies, November.
Tkach and Kandel, Demand for Immediacy: Time is Money, working paper.
Handa, P. and Schwartz, R., 1996, Limit Order Trading, Journal of Finance, 1835-1861.
Duane Seppi, 1997, Limit Orders in the Presence of a Strategic Specialist, Review of Financial Studies
Goettler R.L., Parlour, C. A., Rajan, U., 2003, Welfare in a dynamic limit order market. Unpublished working paper. GSIA, CarnegieMellonUniversity.
Hollifield, B., Miller, R. A., Sandas, P., Slive, J., 2003, Liquidity supply and demand in limit order markets. working paper. GSIA, CarnegieMellonUniversity.
Parlour, Christine A., and Duane J. Seppi, 2003, Liquidity-based competition for order flow, Review of Financial Studies 16, 301-330.
Rosu, Ioanid, 2005, A Dynamic Model of the Limit Order Book, working paper, University of Chicago.
6. Market performance and its measures - empirical evidence. Estimation of trading costs. Comparisons across trading venues.
Biais, Hillion and Spatt, 1995, An Empirical Analysis of the Limit Order Book and the Order Flow in the Paris Bourse, The Journal of Finance, Vol. 50, No. 5 (Dec.,), pp. 1655-1689
Lee, C.M.C., B. Mucklow and M.J. Ready, 1993 "Spreads, Depths and the Impact of Earnings Information: An Intraday Analysis," Review of Financial Studies 6, pp. 345-374.
Barclay et al, 1999, The Effect of the Order Handling Rules on the Trading Cost on Nasdaq, Journal of Finance, February.
Huang and Stoll, 1997, The Components of the Bid-Ask Spread: A General Approach, Review of Financial Studies, Winter 1997.
Easley, Kiefer, O’Hara and Paperman, 1996, Liquidity, Information and Infrequently traded Stocks, Journal of Finance, 51(4).
Glosten, L. and L. Harris, 1988, Estimating the components of the bid-ask spread, Journal of Financial Economics 21, 123-142.
George. Thomas J., Gautam Kaul, and M Nimalendran, 1991, Estimation of the bid-ask spread and its components: a new approach, Review of Financial Studies 4, 623-656.
Glosten, Lawrence R., and Lawrence E. Harris, 1988, Estimating the components of the bid/ask spread, Journal of Financial Economics 21, 123-42.
Chan, Christie and Schultz, 1995, Market structure and the intraday pattern of bid-ask spread on NASDAQ, Journal of Business, 68(1).
Bertsimas, Dimitris, and Andrew Lo, 1998, Optimal control of execution costs, Journal of Financial Markets, 1, 1-50.
Bessembinder, H. and H. Kaufman, 1997, A comparison of trade execution costs for NYSE and Nasdaq-listed stocks, Journal of Financial and Quantitative Analysis 32, 287- 310.
McInish, T., and R. Wood, 1992, An analysis of intraday patterns in bid/ask spreads for NYSE stocks, Journal of Finance 47, 753-764.
Chordia, Tarun, Richard Roll, and Avanidhar Subrahmanyam, 2000, Commonality in liquidity, Journal of Financial Economics 56, 3-28.
Michael Goldstein, Paul Irvine, Eugene Kandel & Zvi Wiener, 2005. "Brokerage Commissions and Institutional Trading Patterns," working paper.
7. Market design - tick size, closing auctions. Multifaceted competition – payment for order flow.
Harris, L., 1991, Stock price clustering and discreteness, Review of Financial Studies 4, 389-415.
Christie and Schultz, 1994, Why do Nasdaq Market Makers Avoid Odd Eights Quotes, Journal of Finance, December.
Kandel and Marx, Nasdaq Market Structure and Spread Patterns, Journal of Financial Economics, July 1997.
Kandel and Marx, Payment for Order Flow on Nasdaq, Journal of Finance, Feb 1999.
Easley, Kiefer, and O’Hara, 1996, Cream Skimming or Profit Sharing? The curious role of purchased order flow, Journal of Finance, 51(3) proceedings.
P. Dutta; A. Madhavan, Competition and Collusion in Dealer markets
The Journal of Finance, Vol. 52, No. 1 (Mar., 1997),
U.S. Securities and Exchange Commission, 1996, Report pursuant to section 21(a) of the securities exchange act of 1934 regarding the NASD and the Nasdaq stock market, US Government Printing Office, Washington, DC.
Barclay, M., 1997, Bid-ask spreads and the avoidance of odd-eighth quotes on Nasdaq: An examination of exchange listings, Journal of Financial Economics 45, 9-34.
Bacidore, J., 1997, The impact of decimalization on market quality: An empirical investigation of the Toronto Stock Exchange, Journal of Financial Intermediation 6.
Goldstein and Kavajecz, 2000, Moving from one eighths to one sixteenths tick on NYSE, Journal of Financial Economics
8. Microstructure and Asset Prices.
Amihud, Y. and H. Mendelson, 1986, Asset pricing and the bid-ask spread, Journal of Financial Economics 17, 223-249.
Constantinides, George, 1986, "Capital Market Equilibrium with Transaction Costs," Journal of Political Economy 94, August, 842-62. Just get the basic idea.
Barclay, Michael J., Kandel, Eugene & Marx, Leslie M., 1998. "The Effects of Transaction Costs on Stock Prices and Trading Volume," Journal of Financial Intermediation, vol. 7(2), pages 130-150.
Easley, David, Soeren Hvidkjaer, and Maureen O'Hara, 2002, Is information risk a determinant of asset returns?, Journal of Finance 57, 2185-2221.
Vayanos, Dimitri, 1998, Transaction Costs and Asset Prices: A Dynamic Equilibrium Model, Review of Financial Studies, 1998, 11, 1-58
Eleswarapu, Venkat R., 1997, Cost of transacting and expected returns in the Nasdaq market, Journal of Finance 52, 2113-2127.
Pastor, Lubos, and Robert F. Stambaugh, 2003, Liquidity risk and expected stock returns, Journal of Political Economy 111, 642-685
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