University of Texas at Dallas School of Management. Finance Seminar in Market Microstructure Spring 2005

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1 University of Texas at Dallas School of Management Finance Seminar in Market Microstructure Spring 2005 Instructor: Kam-Ming Wan Office: SOM Phone: (972) kmwan@utdallas.edu Web-site: Office Hours: Mon. 5-5:50pm & Wed. 3-3;50pm or by appointment Class Time: Monday. 2pm - 4:45pm (SOM 2.802) Course Objectives: The course aims to equip students with basic modeling skills for the understanding of the market microstructure literature. It also intends to enhance students knowledge of how trades executed in the real world. Since market microstructure issues have important policy implications, we will discuss several contemporary topics such as trading costs measurement, Nasdaq collusion puzzle, company choice of listing venues, and decimalization toward the end of the course. Course Requirements: You are required to have basic knowledge of microeconomics and game theory. In terms of mathematical skills, you must be similar with calculus, dynamic programming, and linear algebra. In terms of statistics and econometrics skills, I expect you to know various probability distributions, Bayes rule, and regression models. Knowledge on SAS is recommended but not required. Required Text: Market Microstructure Theory by O Hara, Maureen, 1 st edition, Blackwell, Trading and Exchanges: Market Microstructure for Practitioners by Larry Harris, 1 st edition, Oxford University Press, Supplementary reading: Time Series Analysis by Hamilton, James D., 1 st edition, Princeton University Press, New Jersey, The Econometrics of Financial Markets by Campbell, John, Lo Andrew, and Mackinlay Craig, 1 st edition, Princeton University Press, New Jersey, Probability and Statistics by DeGroot, Morris, 3 rd edition, Addison-Wesley, Boston,

2 Grading: The final grade in this course will be determined according to the following weighting system: Homework: Midterm Exam 30% Final Exam 40% Homework 20% Class Participation 10% There are 3-4 homework assignments during the semester. Each homework assignment counts equally. No late homework is accepted. Data Analysis: At least one homework assignment will involve data analysis using Transaction and Quotation (TAQ) database. TAQ contains intraday quote and transaction records of all stocks listed in major U.S. equity markets. I recommend that you to read the TAQ manual and a handout by Joel Hasbrouck (Working with bid and offer quotes on TAQ) carefully before you attempt your homework assignment. TAQ User s Guide, New York Stock Exchange Inc., Version Class participation: You are required to read the assigned papers (those with *) prior to attending each lecture. I also recommend some articles (those with #) for background reading. Since this is a doctoral seminar, I expect students to participate in discussion. Your attendance, questions, and participation contribute an important learning experience to this class. Class participation contributes up to 10 percentage points of the final score. Attendance: It is mandatory that you attend class. If you can t attend lecture, you have to inform me in advance. Exam Format: Midterm and final examinations are closed-books and -notes. It covers all material covered in lectures. Honor code compliance: Homework: Is to be done by yourself without any consultation. On the presumption that you are graduate students, you will recognize that you do not learn much of the analytical process by relying on someone s else s homework. 2

3 Course Calendar Lecture Date Topics Remark 1 Jan. 10 Course Introduction Market Structure in the US Equity Market Mathematical and Statistics Refresher Jan. 17 Martin Luther King Jr. Day 2 Jan. 24 Inventory Models 3 Jan. 31 Specialist Models 4 Feb. 7 R.E.E Models HW#1 due 5 Feb. 14 Strategic Trader Model I 6 Feb. 21 Strategic Trader Model II 7 Feb. 28 Trading Volume HW#2 due Mar. 7 Mar. 14 Spring Break Midterm 8 Mar. 21 Application of Insider Trading Model 9 Mar. 28 Liquidity and Trading Cost Measurement 10 Apr. 4 Nasdaq Collusion Puzzle HW#3 due 11 Apr. 11 Company Listing Decision 12 Apr. 18 Decimalization 13 Apr. 25 Interface of Market Microeconomics with other areas of Finance HW#4 due May. 2 Final Exam (Comprehensive) 3

4 COURSE OUTLINE Lecture 1 - Introduction Market Structure, Trading System and Procedures in NYSE, AMEX, and NASDAQ *Demsetz Harold, 1968, The Cost of Transacting, Quarterly Journal of Economics 82, *Madhavan, A., 2000, Market Microstructure: A Survey, Journal of Financial Markets 3, *Hasbrouck Joel, 2004, US Equity Markets: Overview and Recent History, NYU Working Paper. Hasbrouck Joel, Sofianos George, and Sosebee Deborah, 1993, New York Stock Exchange Systems and Trading Procedures, NYSE Working Paper# Jeffrey W. Smith, James P. Selway III, and Timothy McCormick, 1998, The Nasdaq Stock Market: Historical Background and Current Operation, NASD Working Paper# O Hara, Chapter 1 Lecture 2 - Inventory Model Inventory Holding Costs *Stoll Hans, 1978, The Supply of Dealer Services in Securities Markets, Journal of Finance 33, *Ho, Thomas, and Hans Stoll, 1981, Optimal Dealer Pricing Under Transactions and Return Uncertainty, Journal of Financial Economics 9, *O Hara, Maureen, and G. Oldfield, 1986, The Microeconomics of Market Making, Journal of Financial and Quantitative Analysis 21, #Hasbrouck Joel, and George Sofianos, 1993, The Trades of Market Makers: An Empirical Analysis of NYSE Specialists, Journal of Finance 48, O Hare, Chapter 2 Amihud, Yakov, and Haim Mendelson, 1980, Dealership Market: Market-Making with Inventory, Journal of Financial Economics 8, Hasbrouck Joel, 1988, Trades, Quotes, Inventories and Information, Journal of Financial Economics 22, Lecture 3 Specialist Models Determinant of bid-ask spread, Adverse Selection, Trade Size *Glosten, Lawrence, Paul Milgrom, 1985, Bid, Ask and Transaction Prices in a Specialist Market with Heterogeneously Informed Traders, Journal of Financial Economics 16, *Easley D, O Hara M, 1987, Price, Trade Size, and Information in Securities Markets, Journal of Financial Economics 19, #O Hara Chapter 3 4

5 Easley D, O Hara M, 1992, Adverse Selection and Large Trade Volume: The Implications for Market Efficiency, Journal of Financial and Quantitative Analysis 27, Harris, Lawrence, 1990, Estimation of Stock Price Variances and Serial Covariances from Discrete Observations, Journal of Financial and Quantitative Analysis 25, Glosten, L. 1989, Insider Trading, Liquidity, and the Role of the Monopolist Specialist, Journal of Business 62, Lecture 4 R.E.E. Model Competitive and Noisy Rational Expectations Equilibrium *Grossman, Sanford, 1976, On the Efficiency of Competitive Stock Markets when Traders have Diverse Information, Journal of Finance, *Grossman Sanford, and Joseph Stiglitz, 1980, On the Impossibility of Informationally Efficient Markets, American Economic Review, *Brown, David P., and Robert H. Jennings, 1989, On Technical Analysis, Review of Financial Studies 2, #DeGroot, Chapter 2, 5.6, 5.12, , 6.7 #O Hara, Chapter 3 (Appendix), and Chapter 4 (Appendix) #Hayek, Friedrich Von, 1945, The Use of Knowledge in Society, American Economic Review 35, Hellwig, Martin, 1980, On the Aggregation of Information in Competitive Markets, Journal of Economic Theory 22, Blume, Lawrence, and David Easley, 1990, Implementation of Walrasian Expectations Equilibria, Journal of Economic Theory 51, Diamond, Douglas W. and Robert Verrecchia, 1981, Information Aggregation in a Noisy Rational Expectations Economy, Journal of Financial Economics, Kyle, Albert S., 1989, Informed Speculation with Imperfect Competition, Review of Economic Studies 56, Lecture 5 Strategic Trader Model I Continuous Auction Model *Kyle, Albert S., 1985, Continuous Auctions and Insider Trading, Econometrica 53, *Holden, C.W., and A. Subrahmanya, 1992, Long-lived Private Information and Imperfect Competition, Journal of Finance 47, #O Hara, Chapter 4 Subrahmanyam, Avanidhar, 1991, Risk Aversion, Market Liquidity, and Price Efficiency, Review of Financial Studies 4(3), Lecture 6 Strategic Trader Model II Intraday and Inter-day Trading Pattern 5

6 *Admati, Anat and Paul Pfleiderer, 1988, A Theory of Intraday Trading Patterns, Volume and Price Variability, Review of Financial Studies, *Foster, F.D., and S. Viswanathan, 1990, A theory of Interday Variations in Volume, Variance and trading Costs in Securities Markets, Review of Financial Studies 3, #O Hara Chapter 5 #Foster, F.D., and S. Viswanathan, 1993, Variation in Trading Volume, Return Volatility, and Trading Costs: Evidence on Recent Price Formation Models Journal of Finance 48, Harris Lawrence, 1986, A Transaction Data Study of Weekly and Intradaily Patterns in Stock Returms, Journal of Financial Economics 16, Chowdhry, Bhagwan, and Vikram Nanda, 1988, A Theory of Intraday Trading Market Liquidity, Review of Financial Studies, Lakonishok, J., and E. Maberly, 1990, The Weekend Effect: Trading Patterns of Individual and Institutional Investors, Journal of Finance 45, Lecture 7 Trading Volume No-Trade Theorem and Different interpretation of the same information *Milgrom, Paul, and Nancy Stokey, 1982, Information, Trade, and Common Knowledge, Journal of Economic Theory 26, *Harris, Milton, and Arthur Raviv, 1993, Difference in Opinion Make a Horse race, Review of Financial Studies 6, #Bernardo, Antonio, and Kenneth L. Judd, 1999, Volume and Price Formation in an Asset Trading Model with Asymmetric Information, Working Paper. O Hara: Chapter 6 Tirole, Jean, 1982, On the Possibility of Speculation Under Rational Expectations, Econometrica 50(5), Wang, Jiang, 1994, A Model of Competitive Stock Trading Volume, Journal of Political Economy 102, Lecture 8 Application to Insider Trading Insider Trading in Pure Exchange Economy Vs. Economy with Production *Leland, Hayne, E., 1992, Insider Trading: Should it be prohibited?, Journal of Political Economy 100, *Hirshleifer, Jack, 1972, The Private and Social Value of Information and the Reward to Inventive Activity, American Economic Review, *Cornell, Bradford, and Eric Sirri, 1992, The Reaction of Investors and Stock Prices to Insider Trading, Journal of Finance 47 (3), #Muelbroek, Lisa, 1992, An Empirical Analysis of Illegal Insider Trading, Journal of Finance 47 (5),

7 Bernardo, Antonio E., 2001, Contractual Restrictions on Insider Trading: A Welfare Analysis, Economic Theory 18, Ausubel, Lawrence M., 1990, Insider Trading in a Rational Expectations Economy, American Economics Review 80, Lecture 9 Liquidity and Trading Cost Measurement Quoted Spread, Effective Spread, Perold Implementation Shortfall, Block Trade *Roll Richard, 1984, A Simple Implicit Measure of the Effective Bid-Ask Spread in an Efficient Market, Journal of Finance 39, *Glosten, Lawrence, L. Harris, 1988, Estimating the Component of the Bid-Ask Spread, Journal of Financial Economics 21, *Harris, chapter 21 *Huang, Roger, H. Stoll., 1997, The Component Of the Bid-Ask Spread: A General Approach, The Review of Financial Studies 10(4), #Perold Andre, 1988, The Implementation Shortfall: Paper Versus Reality. Journal of Portfolio Management 14(3), 4-9 Keim, D., and A. Madhavan, 1996, The Upstairs Market for Large Block Transactions: Analysis and Measurement of Price Effects, Review of Financial Studies 9, Keim, D., and A. Madhavan, 1995, Anatomy of the Trading Process: Empirical Evidence on the Behavior of Institutional Traders, Journal of Financial Economics 37, Laplanta, M, Muscarella, C.J., 1997, Do institutions receive comparable execution in the NYSE and Nasdaq markets? A transaction study of block trades, Journal of Financial Economics, 45, Chan, L., Lakonishok, J., Institutional Equity Trading Costs: NYSE Versus Nasdaq. Journal of Finance 52(2), Bollen, Nicolas, Tom Smith, and Robert Whaley, 2002, Modeling the Bid/Ask Spread: Capturing the Effects of Hedging Costs, Working Paper Contemporary Market Microstructure Issues Lecture 10 - Nasdaq Collusion Puzzle Clustering and SEC Reform *Christie and Schultz, 1994, Why do NASDAQ Market Makers Avoid Odd Eights?, Journal of Finance, *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, *Barclay, M.., Christie W. G., Harris J.H., Kandel E., and Schultz P.H, 1999, Effects of Market Reform on the Trading Costs and Depths of Nasdaq Stocks, Journal of Finance 54, *Christie, G. William, Harris J.H., and Schultz P.H., 1994, Why Did Nasdaq Market Makers Stop Avoding Odd- Eight Quotes," Journal of Finance 49,

8 Bessembinder, H., 1997, The degree of price resolution and equity trading costs, Journal of Financial Economics 45, Demsetz H., 1997, Limit Orders and the Alleged Nasdaq Collusion, Journal of Financial Economics 45 (1) Weston, James, 2000, Competition on the Nasdaq and the Impact of Recent Market Reforms, Journal of Finance 55, Lecture 11 Company s Choices of Listing Venues Domestic and International Firms Choices of Listing Venues *Doidge, Craig, Karolyi A., and Stulz R., 2004, Why are Foreign Firms Listed in the U.S. Worth More?, Journal of Financial Economics 71, *Wan, Kam-Ming, 2004, The Insider Restricted Equity on the Choice of Exchange: An Empirical Studies of the NYSE listing choices of the NASDAQ firms, UTD Working Paper. *Lins Karl, Strickland Deon, and Zenner Marc, 2003, Do non-u.s. firms issue equity on U.S. stock exchanges to relax capital constraints? Journal of Financial and Quantitative Analysis, forthcoming *Anderson, Anne-Marie, and Dyl, E., 2004, Market Structure and Trading Volume. Journal of Financial Research Forthcoming. #Macey, J., Pompilio D., and Maureen O Hara, 2004, Down and Out in the Stock Market: The Law and Finance of the Delisting Process, Working Paper, Johnson Graduate School of Management, Cornell University. Bessembinder, H., and H. M. Kaufman, 1997, A Comparison of Trade Execution Costs for NYSE and NASDAQ-Listed Stocks, Journal of Financial and Quantitative Analysis 32, Atkin, A., and Dyl, E., Market Structure and Reported Trading Volume: Nasdaq versus the NYSE. Journal of Financial Research 20(3), Bessembinder, Hendrik, 2000, On Assessing the Costs and Benefits of the Exchange Listing, NYSE Working Paper. Madhavan, A., 1992, Trading Mechanisms in Securities Markets, Journal of Finance 47, Lecture 12 Decimalization and Tick Size Minimum Price Variation, Stock Split, Liquidity Provision *Lawrence E. Harris, Minimum Price Variations, Discrete Bid-Ask Spreads, and Quotation Sizes, Review of Financial Studies 7 (1), *Bessembinder, H, 2003, Trade Execution Costs and Market Quality after Decimalization, Journal of Financial and Quantitative Analysis 38(4), *Angel James, 1997, Tick Size, Share Prices, and Stock Splits, Journal of Finance, Goldstein, A. Michael, Kavajecz, K.A., 2000, Eighths, Sixteenths, and Market Depth: Changes in Tick Size and Liquidity Provision on the NYSE, Journal of Financial Economics 56, Lawrence E. Harris, 1996, Does a Large Minimum Price Variation Encourage Order Exposure, USC Working paper. 8

9 Lecture 13 Interface of Market Microstructure with Area of Corporate Finance and Others IPO, Costs of Capital, and Investor Breadth *Grullon, Gustavo, Kanatas, George, and Weston, James, 2004, Advertising, Breadth of Ownership, and Liquidity, Review of Financial Studies 17(2), *Ellis, Katrina, Roni Michaely, and Maureen O Hara, 2004, Competition in Investment Banking: Proactive, Reactive or Retaliatory?, Working Paper, Johnson Graduate School of Management, Cornell University *Butler, Alexander, Grullon, Gustavo, and Weston, James, 2003, Does Stock Market Liquidity Matter? Evidence from Seasoned Equity Offerings, Working Paper. *Ellis, Katrina, Roni Michaely, and Maureen O Hara, 2000, When the Underwriter Is the Market Maker: An Examination of Trading in the IPO Aftermarket, Journal of Finance 55(3), Robert Bloomfield, Maureen O Hara, and Gideon Saar, 2003, The Make or Take Decision in an Electronic Market: Evidence on the Evolution of Liquidity, Working Paper. Mendiola, A., and and Maureen O Hara, 2003, Taking Stock in Stock Markets: The Changing Governance of Exchanges, Working Paper, Johnson Graduate School of Management, Cornell University. 9

10 University of Texas at Dallas School of Management Individual Sign-up Sheet FIN 7310 Prof. Kam-Ming Wan Spring 2005 In order for me to better organize the course, and to adapt the materials to your background, would you please tell me more about yourself? Your Name Your Address (Please send me an with your full name, so that I can make up a mailing list) Current Employer and Position Your Background Finance Class Economics Class Statistics and Math Courses Statistics Programming Language Other related Courses Work Experience Picture [Please affix your student ID picture here] 10