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Lecture 6: Introduction to Market Microstructure
IIT KANPUR-NPTEL
Overview
This lecture introduces the concept of market microstructure, explaining how financial markets facilitate the flow of savings to productive sectors. It differentiates between efficient and inefficient prices, defining fundamental prices as those reflecting all relevant information and observed prices as a combination of fundamental value and noise. The video explores market efficiency in three forms: weak, semi-strong, and strong. It also categorizes investor risk preferences into risk-neutral, risk-averse, and risk-preferring, noting that investors are typically risk-averse. Different market structures, including quote-driven (broker-dealer) and order-driven (limit order books) markets, are discussed, along with primary vs. secondary markets and call vs. continuous auction markets. Finally, it examines market participants like informed traders, noise/liquidity traders, and market makers, and theoretical underpinnings such as inventory and information asymmetry hypotheses.
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Chapters
- •Financial markets channel savings to productive sectors through financial intermediation.
- •Efficient and liquid markets are crucial for economic function.
- •Observed prices fluctuate around fundamental (efficient) prices due to noise and sentiment.
- •Arbitrageurs exploit price inefficiencies, though true riskless arbitrage is rare due to transaction costs.
- •Weak-form efficiency: No profits from past price/trading data.
- •Semi-strong form efficiency: No profits from past data or public information.
- •Strong-form efficiency: No profits from past data, public, or private information.
- •Market efficiency influences trading strategies and potential for profit.
- •Utility functions describe investor preferences for wealth outcomes.
- •Non-satiation: More wealth is generally preferred to less.
- •Risk-neutral: Indifferent to risk; utility is linear.
- •Risk-averse: Prefers certain outcomes; utility function is concave.
- •Risk-preferring: Prefers riskier outcomes; utility function is convex.
- •Quote-driven markets (broker-dealer) use dealers/market makers providing continuous bid/ask quotes.
- •The bid-ask spread represents dealer profit and market liquidity.
- •Order-driven markets (limit order books) rely on limit and market orders without designated market makers.
- •Limit orders provide liquidity; market orders consume liquidity.
- •Primary markets: New securities issuance (e.g., IPOs).
- •Secondary markets: Trading of existing securities.
- •Continuous auction markets: Continuous matching of buy/sell orders.
- •Call auction markets: Trading occurs at discrete intervals (e.g., opening/closing sessions).
- •Noise traders trade without significant information, adding noise to prices.
- •Liquidity traders trade to obtain liquidity, also adding noise.
- •Informed traders use information to exploit inefficiencies, increasing price efficiency.
- •Market makers provide liquidity and manage inventory, adjusting quotes and spreads.
- •Inventory hypothesis: Market makers charge spread to cover inventory risk.
- •Information asymmetry hypothesis: Market makers charge spread to cover potential losses against informed traders.
- •Limit order books operate on time-price priority for order execution.
- •Best bid (highest buy price) and best ask (lowest sell price) determine the spread.
- •Relative spread (scaled by mid-price) is a comparable measure of liquidity.
- •Impact cost measures the price effect of a trader's own trades.
- •Stop-loss orders convert to market orders when a predefined price is reached.
Key Takeaways
- 1Financial markets are essential for intermediation, but observed prices contain noise, making them inefficient.
- 2Market efficiency is categorized into weak, semi-strong, and strong forms, impacting trading strategies.
- 3Investor risk preferences (averse, neutral, preferring) are modeled using utility functions, with risk aversion being most common.
- 4Modern markets are primarily order-driven (limit order books), where limit orders act as de facto market makers.
- 5Liquidity is a key market characteristic, reflected in measures like the bid-ask spread and impact cost.
- 6Market participants include informed traders who enhance efficiency, and noise/liquidity traders who add volatility.
- 7Market makers manage inventory and information asymmetry risks, reflected in their pricing strategies (spreads).
- 8Call auctions are used for price discovery, especially during market openings and closings, to protect uninformed traders.