Market Microstructure

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Market Microstructure Hans R. Stoll Owen Graduate School of Management Vanderbilt University Nashville, TN 37203 Hans.Stoll@Owen.Vanderbilt.edu

Financial Markets Research Center Working paper Nr. 01- 16

First draft: July 3, 2001 This version: August 15, 2002 Corrected May 19, 2003

Forthcoming Handbook of the Economics of Finance, edited by G.M. Constantinides, M. Harris, and R. Stulz, 2003, Elsevier Science B.V.

JEL classification: G20, G24, G28, G10, G14. Key words: bid-ask spread; price impact, market design, dealer market, auction market, short-run price behavior, market fragmentation.

Market Microstructure Hans R. Stoll

Abstract Market microstructure deals with the purest form of financial intermediation -- the trading of a financial asset, such as a stock or a bond. In a trading market, assets are not transformed but are simply transferred from one investor to another. The field of market microstructure studies the cost of trading securities and the impact of trading costs on the short-run behavior of securities prices. Costs are reflected in the bid-ask spread (and related measures) and in commissions. The focus of this chapter is on the determinants of the spread rather than on commissions. After an introduction to markets, traders and the trading process, I review the theory of the bid-ask spread in section II and examine the implications of the spread for the short run behavior of prices in section III. In section IV, the empirical evidence on the magnitude and nature of trading costs is summarized, and inferences are drawn about the importance of various sources of the spread. Price impacts of trading from block trades, from herding or from other sources, are considered in section V. Issues in the design of a trading market, such as the functioning of call versus continuous markets and of dealer versus auction markets, are examined in section VI. Even casual observers of markets have undoubtedly noted the surprising pace at which new trading markets are being established even as others merge. Section VII briefly surveys recent developments in U.S securities markets and considers the forces leading to centralization of trading in a single market versus the forces leading to multiple markets. Most of this chapter deals with the microstructure of equities markets. In section VIII, the microstructure of other markets is considered. Section IX provides a brief discussion of the implications of microstructure for asset pricing. Section X concludes.

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Market Microstructure Hans R. Stoll Market microstructure deals with the purest form of financial intermediation -- the trading of a financial asset, such as a stock or a bond. In a trading market, assets are not transformed (as they are, for example, by banks that transform deposits into loans) but are simply transferred from one investor to another. The financial intermediation service provided by a market, first described by Demsetz (1968) is immediacy. An investor who wishes to trade immediately – a demander of immediacy – does so by placing a market order to trade at the best available price – the bid price if selling or the ask price if buying. Bid and ask prices are established by suppliers of immediacy. Depending on the market design, suppliers of immediacy may be professional dealers that quote bid and ask prices or investors that place limit orders, or some combination. Investors are involved in three different markets – the market for information, the market for securities and the market for transaction services. Market microstructure deals primarily with the market for transaction services and with the price of those services as reflected in the bid-ask spread and commissions. The market for securities deals with the determination of securities prices. The literature on asset pricing often assumes that markets operate without cost and without friction whereas the essence of market microstructure research is the analysis of trading costs...
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