The way in which securities are traded is very different from the idealized picture of a frictionless and self-equilibrating market offered by the typical finance textbook. Market Liquidity offers a more accurate and authoritative take on liquidity and price discovery. The authors start from the assumption that not everyone is present at all times simultaneously on the market, and that even the limited number of participants who are have quite diverse information about the security's fundamentals. As a result, the order flow is a complex mix of information and noise, and a consensus price only emerges gradually over time as the trading process evolves and the participants interpret the actions of other traders. Thus a security's actual transaction price may deviate from its fundamental value, as it would be assessed by a fully informed set of investors. This book takes these deviations seriously, and explains why and how they emerge in the trading process and are eventually eliminated. The authors draw on a vast body of theoretical insights and empirical findings on security price formation that have accumulated in the last thirty years, and have come to form a well-defined field within financial economics known as 'market microstructure.' Focusing on liquidity and price discovery, they analyze the tension between the two, pointing out that when price-relevant information reaches the market through trading pressure rather than through a public announcement, liquidity suffers. The book also confronts many puzzling phenomena in securities markets and uses the analytical tools and empirical methods of market microstructure to understand them. These include issues such as why liquidity changes over time, why large trades move prices up or down, and why these price changes are subsequently reversed, why we see concentration of securities trading, why some traders willingly disclose their intended trades while others hide them, and why we observe temporary deviations from arbitrage prices.
PREFACE ; INTRODUCTION ; 0.1 WHAT IS THIS BOOK ABOUT? ; 0.2 WHY SHOULD WE CARE? ; 0.3 SOME PUZZLES ; 0.4 THE THREE DIMENSIONS OF LIQUIDITY ; 0.4.1 MARKET LIQUIDITY ; 0.4.2 FUNDING LIQUIDITY ; 0.4.3 MONETARY LIQUIDITY ; I INSTITUTIONS ; 1 MARKET STRUCTURE AND TRADING MECHANICS ; 1.1 INTRODUCTION ; 1.2 LIMIT ORDER MARKETS AND DEALER MARKETS ; 1.2.1 LIMIT ORDER MARKETS ; 1.2.2 DEALER MARKETS ; 1.2.3 HYBRID MARKETS ; 1.2.4 MARKET TRANSPARENCY ; 1.3 DOES MARKET STRUCTURE MATTER? ; 1.4 EVOLUTION OF MARKET STRUCTURE ; 1.4.1 WHO MAKES THE RULES? ; 1.4.2 COMPETITION BETWEEN EXCHANGES ; 1.4.3 AUTOMATION ; 1.5 FURTHER READING ; 1.6 EXERCISES ; 2 MEASURING LIQUIDITY ; 2.1 INTRODUCTION ; 2.2 MEASURES OF THE SPREAD ; 2.2.1 THE QUOTED SPREAD ; 2.2.2 THE EFFECTIVE SPREAD ; 2.2.3 THE REALIZED SPREAD ; 2.3 OTHER MEASURES OF IMPLICIT TRADING COSTS ; 2.3.1 VOLUME-WEIGHTED AVERAGE PRICE ; 2.3.2 MEASURES BASED ON PRICE IMPACT ; 2.3.3 NON-TRADING MEASURES ; 2.3.4 MEASURES BASED ON RETURN COVARIANCE ; 2.4 IMPLEMENTATION SHORTFALL ; 2.5 HANDS-ON ESTIMATION OF TRANSACTION COSTS ; 2.6 FURTHER READING ; 2.7 APPENDIX ; 2.8 EXERCISES ; 3 ORDER FLOW, LIQUIDITY AND SECURITIES PRICE DYNAMICS ; 3.1 INTRODUCTION ; 3.2 PRICE DYNAMICS AND THE EFFICIENT MARKET HYPOTHESIS ; 3.3 PRICE DYNAMICS WITH INFORMATIVE ORDER FLOW ; 3.3.1 THE GLOSTEN-MILGROM MODEL ; 3.3.2 THE DETERMINANTS OF THE BID-ASK SPREAD ; 3.3.3 HOW DO DEALERS REVISE THEIR QUOTES? ; 3.3.4 PRICE DISCOVERY ; 3.3.5 THE IMPLICATIONS FOR PRICE MOVEMENTS AND VOLATILITY ; 3.4 PRICE DYNAMICS WITH ORDER-PROCESSING COSTS ; 3.4.1 BID-ASK SPREAD WITH ORDER-PROCESSING COSTS ; 3.4.2 PRICE DYNAMICS WITH ORDER-PROCESSING AND ADVERSE-SELECTION COSTS ; 3.5 PRICE DYNAMICS WITH INVENTORY RISK ; 3.5.1 A TWO-PERIOD MODEL ; 3.5.2 A MULTI-PERIOD MODEL ; 3.5.3 THE DYNAMICS OF PRICES AND INVENTORIES ; 3.6 THE FULL PICTURE ; 3.7 FURTHER READING ; 3.8 EXERCISES ; 4 TRADE SIZE AND MARKET DEPTH ; 4.1 INTRODUCTION ; 4.2 MARKET DEPTH UNDER ASYMMETRIC INFORMATION ; 4.2.1 LEARNING FROM ORDER SIZE ; 4.2.2 PERFECTLY COMPETITIVE DEALERS ; 4.2.3 INFORMED TRADER'S ORDER PLACEMENT STRATEGY ; 4.2.4 IMPERFECTLY COMPETITIVE DEALERS ; 4.3 MARKET DEPTH WITH INVENTORY RISK ; 4.3.1 PERFECTLY COMPETITIVE DEALERS ; 4.3.2 IMPERFECTLY COMPETITIVE DEALERS ; 4.4 FURTHER READING ; 4.5 APPENDIX A ; 4.6 APPENDIX B ; 4.7 EXERCISES ; 5 ESTIMATING THE DETERMINANTS OF MARKET ILLIQUIDITY ; 5.1 INTRODUCTION ; 5.2 PRICE IMPACT REGRESSIONS ; 5.2.1 WITHOUT INVENTORY COSTS ; 5.2.2 WITH INVENTORY COSTS ; 5.3 MEASURING THE PERMANENT IMPACT OF TRADES ; 5.4 PROBABILITY OF INFORMED TRADING (PIN) ; 5.5 FURTHER READING ; 5.6 EXERCISES ; II MARKET DESIGN AND REGULATION ; 6 LIMIT ORDER BOOK MARKETS ; 6.1 INTRODUCTION ; 6.2 A MODEL OF THE LIMIT ORDER BOOK (LOB) ; 6.2.1 THE MARKET ENVIRONMENT ; 6.2.2 EXECUTION PROBABILITY AND ORDER SUBMISSION COST ; 6.2.3 LIMIT ORDER TRADING WITH INFORMED TRADING ; 6.3 DESIGN OF LOB MARKETS ; 6.3.1 TICK SIZE ; 6.3.2 PRIORITY RULES ; 6.3.3 HYBRID LOB MARKETS ; 6.4 THE MAKE OR TAKE DECISION IN LOB MARKETS ; 6.4.1 RISK OF BEING PICKED OFF AND RISK OF NON EXECUTION ; 6.4.2 BID-ASK SPREADS AND EXECUTION RISK ; 6.4.3 BID-ASK SPREADS AND VOLATILITY ; 6.4.4 INDEXED LIMIT ORDERS, MONITORING, AND ALGORITHMIC TRADING ; 6.4.5 ORDER FLOW AND THE STATE OF THE LOB ; 6.5 FURTHER READING ; 6.6 EXERCISES ; 7 MARKET FRAGMENTATION ; 7.1 INTRODUCTION ; 7.2 THE COSTS OF FRAGMENTATION ; 7.2.1 INFORMATION EFFECTS ; 7.2.2 RISK-SHARING EFFECTS ; 7.2.3 COMPETITION AMONG LIQUIDITY SUPPLIERS ; 7.2.4 FRAGMENTATION AND THE BROKER-CLIENT RELATIONSHIP ; 7.3 LIQUIDITY EXTERNALITIES ; 7.3.1 LIQUIDITY BEGETS LIQUIDITY ; 7.3.2 LOW-LIQUIDITY TRAPS ; 7.4 THE BENEFITS OF FRAGMENTATION ; 7.4.1 CURBING THE PRICING POWER OF EXCHANGES ; 7.4.2 SHARPER COMPETITION AMONG LIQUIDITY PROVIDERS ; 7.4.3 TRADE-THROUGHS ; 7.5 REGULATION ; 7.5.1 REGULATION NMS ; 7.5.2 MIFID ; 7.6 FURTHER READING ; 7.7 EXERCISES ; 8 MARKET TRANSPARENCY ; 8.1 PRE-TRADE TRANSPARENCY ; 8.1.1 QUOTE TRANSPARENCY AND COMPE
