Microstructure: Theory and Empirics

Transcription

1 Microstructure: Theory and Empirics Institute of Finance (IFin, USI), March 16 27, 2015 Instructors: Thierry Foucault and Albert J. Menkveld

2 Course Outline Lecturers: Prof. Thierry Foucault (HEC Paris) and Prof. Albert J. Menkveld (VU) Short subject description: The purpose of the course is to acquaint students with the field of market microstructure, both theoretically and empirically. Course contents: Market microstructure has grown rapidly as an important subfield of finance. Research in this field focuses on the intertwined relationships between volatility, liquidity, price discovery, market design, and ultimately welfare. Models in market microstructure provide a framework for the analysis of price movements and trading volume. Frontier research in market microstructure is focused on the economics of electronic markets (in particular, high frequency trading) and interactions between liquidity, asset prices, and managerial decisions (e.g., investment). The new eco system that technology facilitated and discovery that illiquidity affects asset prices have renewed interest in the field. Not only academics, but also regulators and market participants try to make economic sense of a variety of market structures (traditional exchanges, multilateral trading facilities, internalization pools, dark pools, etc.), algorithmic trading, high-frequency trading, etc. Many of the tools developed for human-intermediated market are still relevant for today s markets, but additional tools and models are actively being developed. Course objective: After the course students are aware of canonical models in microstructure. They will also be able to complement the models, interpret the outcomes, and assess the strong points as well as the limitations of these models. They have also learned what the appropriate econometric models are to test the predictions of microstructure models. They are aware of why particular models should be used and understand their relative advantages and drawbacks. Required literature: Foucault, Pagano, and Röell (2013). Market Liquidity: Theory, Evidence, and Policy, Oxford University Press, New York. Hasbrouck (2007). Empirical Market Microstructure, Oxford University Press, New York.

3 Microstructure Theory Instructor: T. Foucault, HEC, Paris. E.mail: Tel: Web: Objectives Expose the market microstructure approach to security prices formation. Describe theoretical tools in market microstructure Give an overview of recent developments in research on market microstructure. The course is self-contained but familiarity with game theory and information economics (signaling, screening) would be helpful. It is organized around 2 topics: (i) order flow, liquidity and price dynamics, and (ii) limit order markets. For each topic I prepared overheads that summarize the main points of each lecture. I will not necessarily cover all the materials in overheads. Lectures are based on Chapters 3, 4, 9 and 10 in Foucault, Pagano and Röell (2013): Market liquidity: Theory, Evidence, and Policy, Oxford University Press. At the end of the syllabus, I reference useful background readings for each lecture. These are not required to follow the course. The organization of the theory part of the course is as follows.

4 Lecture 1 (March 16-1:30 p.m to 4:30 p.m) Introduction. The Market Microstructure Approach Goal: Describe the main themes/issues in market microstructure; Introducing some definitions/concepts (order flow, liquidity demanders-suppliers, price impact, liquidity, bid-ask spread, market depth). Puzzles. Lecture notes: Introduction in Foucault, Pagano and Roëll (2013) Overheads: Introduction. Topic 1. Order Flow, Liquidity and Price Dynamics Goals: (i) Explain why and how order imbalances move stock prices and (ii) explain basic determinants of market illiquidity (asymmetric information, inventory holding costs, and order processing costs) 1. A simple model of trading with asymmetric information; Price Discovery and Bid-Ask Spread; Adverse Selection Costs and Order Processing Costs. Overheads: Price dynamics and liquidity I. Lecture notes: Chapter 3 in Foucault, Pagano and Roëll (2013). 2. Introducing order processing costs and inventory effects. Overheads: Price dynamics and liquidity II. 3. Lecture notes: Chapter 3 in Foucault, Pagano and Roëll (2013). Lecture 2 (March 17-1:30 to 4:00 p.m) Topic 2. Strategic Behavior and Price Formation Goals: Present strategic models of trading in market microstructure. How do informed investors choose their trade size? Why do trade sizes contain information? Trade size and price impacts. 1. Kyle (1985) s model: static and dynamic case 2. Effect of market power Overheads: Trade Size and market depth. Lecture notes: Chapter 4 in Foucault, Pagano and Roëll (2013).

5 Lecture 3 (March 18-1:30 to 4:00 p.m) Topic 3. Asset Prices and Liquidity Goal: Explain how illiquidity affect asset prices 1. Illiquidity premium and asset prices 2. Liquidity risk 3. Funding and market liquidity and limits to arbitrage Overheads: Liquidity and Asset Prices I and II Lecture notes: Chapter 9 in Foucault, Pagano and Roëll (2013). Lecture 4 (March 20, 1:30 to 4:00 p.m) Topic 4. Market Microstructure and Corporate Finance Goal: Explain how market liquidity affects firms investment decisions. 1. Monitoring 2. Managerial learning and feedback effects 3. Managerial compensation and incentives Overheads: Liquidity, price discovery, and corporate finance I and II Lecture notes: Chapter 10 in Foucault, Pagano and Roëll (2013).

6 Empirical Market Microstructure Instructor: Albert J. Menkveld: VU University Amsterdam E.mail: Tel: Web: Objectives Develop and explain relevant parts of time series econometrics. Discuss how these econometrics tools are useful to gauge the validity of theoretical models. Work through examples to develop further intuition for what empirical models can and cannot do. Develop sensitivity towards pitfalls both in applying techniques and interpreting results. Discuss the power of structural econometrics, but also its weaknesses. Go through the classic theoretical microstructure models (presented in the theory part of the course) and discuss appropriate tools to take these to the data. Discuss frontier research in the area of empirical market microstructure. The organization of the empirical part of the course is as follows.

7 Lecture 5 (March 23-1:30 to 4:30 p.m) Topic 5. Introduction to time series econometrics Goal: familiarize with econometric techniques to estimate, for example, Roll (1984) and and Glosten and Milgrom (1985). Lecture notes: Hasbrouck (2007) chapter 4 and 6. Overheads: empirical market microstructure. Lecture 6 (March 24-1:30 to 4:30 p.m) Topic 6. State-of-the-art time series econometrics Goal: expand set of econometric techniques to estimate, for example, a generalized Roll (1984) model, multiple markets or multiple securities models (or both), and inventory models, e.g., Stoll (1978). Lecture notes: Hasbrouck (2007) chapter 8 through 11. Overheads: empirical market microstructure. Lecture 7 (March 26-1:30-4:30 p.m.) Topic 6 (cont d). State-of-the-art time series econometrics Goal: expand set of econometric techniques to estimate, for example, a generalized Roll (1984) model, multiple markets or multiple securities models (or both), and inventory models, e.g., Stoll (1978). Lecture notes: Hasbrouck (2007) chapter 8 through 11. Overheads: empirical market microstructure.

8 Lecture 8 (March 27-1:30-4:30 p.m.) Topic 7. The Age of Electronic Trading Goal: Focus on institutional changes in securities markets. Is 21 st century trading same wine in new jars? Lecture notes: Recent papers (see Readings section below). Overheads: empirical market microstructure.

9 Readings Introduction Biais, Glosten and Spatt (2005): «Market Microstructure : A Survey of Microfoundations, Empirical Results and Policy Implications», Journal of Financial Markets, 8, Madhavan, A., (2000), «Market Microstructure : A Survey», Journal of Financial Markets, 3, Topic 1. Order Flow, Liquidity, and Price Dynamics Glosten, L. and Milgrom, P., (1985), Bid, Ask, and Transaction Prices in a Specialist Market With Heterogeneously Informed Traders, Journal of Financial Economics 14, Ho, T., Stoll, H. (1981), "Optimal Dealer Pricing under Transaction and Return Uncertainty", Journal of Financial Economics, 9, Hendershott, T. and Menkveld, A. (2014), Price pressures, Journal of Financial Economics, forthcoming. Kirilenko, Andrei, Albert Kyle, Mehrdad Samadi, and Tugkan Tuzun} (2011): The Flash Crash: The Impact of High Frequency Trading on an Electronic Market. Available at: Topic 2. Strategic behavior and price formation Kyle, A., (1985), Continuous Auctions and Insider Trading, Econometrica 53, Kyle, A. (1989), "Informed speculation with imperfect competition", Review of Economic Studies, 56, Foucault, T, Hombert, J., and Rosu, I. (2014), News trading and speed. Available at: Topic 3. Asset Prices and liquidity Acharya, Viral V., and Lasse Heje Pedersen, 2005, Asset pricing with liquidity risk, Journal of Financial Economics 77, Amihud, Yakov, and Haim Mendelson, 1986, Asset pricing and the bid-ask spread, Journal of Financial Economics 17, Duffie, Darrell, Nicolae Gârleanu, and Lasse Heje Pedersen, 2005, Over-the-counter markets, Econometrica 73, Easley, David, Soeren Hvidkjaer, and Maureen O'Hara, 2002, Is information risk a determinant of asset returns?, Journal of Finance 57,

10 Gromb, Denis, and Dimitri Vayanos, 2010, Limits of arbitrage: The state of the theory, Annual Review of Financial Economics 2, Topic 4. Market microstructure and corporate finance Bond, Philip, Alex Edmans, and Itay Goldstein, 2011, The real effects of financial market, Annual Review of Financial Economics. Foucault Thierry and Frésard Laurent, Learning from peers stock prices and corporate investment. Journal of Financial Economics 111, Holmström, Bengt, and Jean Tirole, 1993, Market liquidity and performance monitoring, Journal of Political Economy 101, Maug, Ernst, 1998, Large shareholders as monitors: Is there a tradeoff between liquidity and control?, Journal of Finance 53, Topic 5. Introduction to Time Series Econometrics Hasbrouck, J. (2007), Empirical Market Microstructure, Oxford University Press. Topic 6. State-of-the art Time Series Econometrics Hasbrouck, J. (2007), Empirical Market Microstructure, Oxford University Press. Topic 7. The Age of Electronic Trading Brogaard, Jonathan, Terrence Hendershott, and Ryan Riordan, 2014, High frequency trading and price discovery, Review of Financial Studies (forthcoming). Budish, Eric, Peter Cramton, and John Shim, The High-Frequency Trading Arms Race: Frequent Batch Auctions as a Market Design Response, R&R Quarterly Journal of Economics. Available at: Hagstromer, Björn, and Lars Norden, 2013, The diversity of high-frequency traders, Journal of Financial Markets 16, Hendershott, Terrence, Charles M. Jones, and Albert J. Menkveld, 2011, Does algorithmic trading improve liquidity?, Journal of Finance 66, Jovanovic, Boyan, and Albert J. Menkveld (2014), Middlemen in limit-order markets, working paper, NYU. Available at:

11 Gross-Klussmann, Axel, and Nikolaus Hautsch, 2011, When machines read the news: Using automated text analytics to quantify high frequency news-implied market reactions, Journal of Empirical Finance 18, Kirilenko, Andrei, Albert (Pete) Kyle, Mehrdad Samadi, and Tugkan Tuzun (2010), The flash crash: The impact of high frequency trading on an electronic market, working paper, U of Maryland. Available at: SEC (2010), Concept release on equity market structure, Release No ; File No. S