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ECON0001 Week 1
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Week 1Institutional details and measures of liquidity
FPR Ch.0-2
Price formation
• Traditional approach to financial economics, the price formation process is a ‘black box’
• In the standard economics paradigm it is the intersection of supply and demand curves for a
particular good
• Two traditional approaches to price formation
◦ It is irrelevant: what matters is the equilibrium, so only need to solve for market clearing
‣ Implicit in this approach is that the trading mechanism plays no role in determining the
equilibrium, so that whichever mechanism is employed the equilibrium is the same
◦ Fiction of the walrasian auctioneer
‣ Traders submit demand schedules to the auctioneer
‣ There is no trading allowed outside equilibrium and incentive issues are not considered
Frictions
Frictionless vs friction
• Frictionless securities markets
◦ All market participants are in the same market at the same time, and are price takers
◦ An auctioneer finds the market clearing price that reflects the “consensus” view on the
security’s fundamentals
◦ Order-flow has no impact on prices
◦ Information is assumed to be homogeneous
◦ There are no “frictions” (commissions, cost to acquire information)
• Frictions in real world markets
◦ Not all market participants may be in the market at the same time or in the same physical/
virtual location
◦ Not everybody shares the same information Expected priceprior oftraderi y
◦ The order flow impacts transaction prices Bia all
infocity
Exogenous
◦ Information is endogenous Endogenousinfoxilyi.ptlyi.tl
◦ Prices deviate from perfect market “consensus”
‣ Extent of deviation: “Illiquidity” i e measureofe aseogfettingwhatyou want
‣ Speed of convergence to consensus: “Price discovery”
Importance of frictions
• Illiquid markets high trading costs, which lower securities’ returns leading investors to demand
, offsetting discount higher cost of capital
• Slow discovery errors in investment decisions (individuals and companies)
Market microstructures
• Study of price formation that explicitly accounts for the existence of frictions
• Market microstructure analyses how specific trading protocols affect the price formation process
• Useful for the regulation of markets and the design and formulation of new trading mechanisms
Models
Inventory-based models
• Primary role assigned to market-makers as liquidity providers
• Bid-ask spread compensate them for price risk on inventory
2 Information-based models
• Traders have asymmetric information on the assets’ true value
• The bid-ask spread compensates for adverse selection costs
The players
• Any trading mechanism can be viewed as a type of trading game in which players meet (perhaps
not physically) at some venue and act according to some rules
• The players may involve a wide range of market participants, although not all types of players are
found in every market mechanism
◦ Traders/investors: the end-“consumers” or suppliers of the asset
‣ Retail investors vs institutional investors
‣ Informed vs uninformed investors
◦ Brokers: the intermediaries who relay investors’ orders to the market (investment banks)
◦ Dealers/market-makers: match orders from different sides of the market
Trading venues
• Exchange trading
◦ Regulated
◦ Liquidity and stability through market makers
◦ Clearing and settlement, ie. ownership of money and assets is verified
◦ Transparency
• Over-the-counter (OTC) trading
◦ Off-exchange venues
‣ Use quotation systems to match dealers and traders
‣ No guarantee of liquidity
Sellascendingprice
‣ No transparency: may not publish trade information
Buydescending
Trading mechanisms
• Order driven
◦ Call/ batch limit order markets:
‣ Orders are collected (in a batch) and cleared at a
certain frequency (eg. Once a day)
‣ The price is chosen so that the market clears
‣ Uniform price: all executable orders are filled at the
same price
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