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Market Microstructure and Market Making
Stephan Luck
Princeton University
September 17, 2018
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Table of Contents
1 Institutions and Some Terminology
2 Liquidity
3 Order Flow, Liquidity, and Securities Price Dynamics

Learning from Order-flow: Glosten-Milgrom model
Price Dynamics with Order-Processing Costs
Price Dynamics with Inventory Risk
4 Trade Size and Market Depth

Learning from Order-Size: Kyle model
Imperfectly Competitive Dealers
5 Limit Order Book Markets

Execution Probability and Order Submission Costs
Limit Order Trading with Informed Investors: Glosten model
6 Liquidity and Asset Pricing

Liquidity and Asset Pricing
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Trading Mechanics and Market Structure
Securities markets mechanisms for bringing buyers and sellers together to trade in
order to
mitigate risks (hedging)
desire to exploit superior information (speculation)
urge to rebalance a portfolio (liquidity shocks)
However,
typical asset pricing models (such as CAPM) does not lay out trading mechanism
and assumes its unimportant for securities prices
Yet, trading rules affect prices!
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Mechanics and Structure
A trading mechanism defines the ”rules of the game”

actions,
information about actions,
protocol for matching buy and sell orders
market structure
Possible rules can be put together in a virtually boundless number of combination

Focus on two prototype trading mechanisms
dealer market (quote driven): specialized market makers/dealers (intermediaries) post
bid and ask
limit order market (order driven): bids and offers are consolidated via limit order book
(LOB)
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Bid and Ask
The price at one can buy a security is called the offer price or ask price.
The price at one can sell a security is the bid price.
The difference between the two prices is called the bid-ask spread
Buying and selling the security from a market maker (round-trip transaction)
means paying the bid-ask spread
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Order Types
Orders represent various mechanisms for executing transactions

Market orders: Non-contingent order, which specifies quantity and direction of
trade
Limit orders: Price-contingent order, which specifies quantity, direction of trade,
as well as a limit price
Further variants:
Stop orders: A stop order becomes a market order to buy or sell securities once
the specified stop price is attained or penetrated
Fill-or-kill: Order must execute as a complete order as soon as it becomes
available on the market, otherwise the order is cancelled
Good-till-cancelled: Order will continue to remain outstanding in the market
place until it executes or is cancelled
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Limit order market and dealer markets
Limit order markets

centralized trading mechanisms in which potential participants can show interest
in trading by submitting limit and market order
Order are matched by a trading platform
Examples: ECNs (electronic communications networks), BATS
(https://www.batstrading.com/), Chi-X (http://www.chi-x.com/)
Dealer markets
Intermediation by professional dealers (dealer 6= brokers 6= broker-dealers)
Quote ask prices at which public can buy, and bid prices at which public can sell
Sellers and trader do not interact directly
Examples: corporate bond market in the US (OTC market)
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Hybrid markets
Many securities markets are hybrid, combining both features
Typical feature: limit order book + some dealers trade some securities
London Stock Exchange: different trading mechanisms according to a stock’s
volume and market capitalisation
hybrid platform (SETS) that combines a limit order market with market making
dealer market (SEAQ) for fixed income securities
see this link here
NYSE: floor brokers, monopolistic specialist, LOB

NASDAQ: multiple competing dealers
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Limit order markets and the Limit order book (LOB)
Buy and sell orders from final investors are matched directly via a single
marketplace
Marketplace can be a trading floor of an exchange or a virtual trading venue run
by computer
Orders are documented into a limit order book (LOB)
The LOB determines the priority with which they will be matched with offsetting
orders
Continuous trade
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Call limit order market
Matching only at discrete points in time

All order are cleared at the same price
Walras was inspired by Paris Bourse call auction when formalizing how supply and
demand are equated in competitive markets
Call mechanism serve as device to determine opening prices or infrequently traded
securities
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Forming Initial limit order book of the trading day
Today, the call mechanism, serves as a mechanism to determine the starting price and
the initial LOB in continuous limit order markets:
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Dealer markets
Final investors do not trade directly with each other but must contact a dealer
Sharp distinction between liquidity suppliers (dealers) and liquidity demander
(final investors)
Quotes are not necessarily public
NASDAQ: real-time information on quotes
OTC markets: shopping
Quotes are typically only valid for a limited number of shares
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Evolution of market structure
Exchanges that emerged from informal trading

First modern exchange: Amsterdam Stock exchange, transferable shares of Dutch
East India Company issued in 1602
London Stock Exchange developed from informal trading that took place in
coffee shops, turned into regulated exchange in 1801
NYSE created in 1792 from informal trading in government securities
Exchanges created by the government
Paris Stock exchange was created on order of Royal Council of State in 1724,
trading conducted by government-appointed agents de change which were pure
brokers
The Vienna Stock Exchange (1771) as well as the Milan Stock Exchange (1808)
were established to trade only government bonds
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Three types of liquidity
Market liquidity
Indicates the ability to trade a security quickly at a price close to its consensus
value
Funding liquidity
When referring to banks or companies, liquidity is taken to mean having sufficient
cash or the ability to obtain credit at acceptable terms to meet obligations
without incurring large losses
Market and funding liquidity are clearly related (more on this later)
Monetary liquidity
Liquidity is often identified with money itself (monetary base or broader monetary
aggregates M1, M2, M3)
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Market liquidity
If the structure of a securities market is compared to car design, measuring liquidity

can be compared to assessing the car’s performance
fuel, efficiency, speed, safety,...
Dimension of market liquidity
trading costs
the depth available to customers placing large orders
price impact
speed of execution
...
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Measuring liquidity: the quoted spread
Difference between the best ask quote a and the best bid quote b is referred to as
the quoted bid-ask spread S = a − b
Normalized by the midprice m = (a + b)/2, one obtains the relative quoted spread
S a−b
s≡ =
m m
Good measure of trading costs for order that are small such that they are entirely
filled at best quotes (Best Bid and Offer, BBO)
For larger order: use weighted average bid-ask spread
Suppose the average execution price for a buy market order of size q is ā(q), and
b̄(q) the average execution price for a sell order
The weighted-average bid-ask spread for an order of size q is thus
S(q) = ā(q) − b̄(q)
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Measuring liquidity: the quoted spread
The relative-weighted average bid-ask spread is
ā(q) − b̄(q)
s(q) ≡
m
When q is small, the entire offer can be filled at BBO
As the quantity (trade size) increases s(q) will increase
The deeper the market, the milder the increase in the spread s(q)
Drawbacks: requires data on limit order at various points in time, and for large
order price points beyond BBO
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Measuring Liquidity: the effective spread
Quoted spread measures trading costs at a given point in time for a hypothetical
transaction
Instead: measure trading cost by using prices actually obtained
Effective half-spread: difference between the price at which a market order
executed and the midquote on the market in the instant before
Se ≡ d(p − m)
where d ∈ {−1, 1} is the order direction, and m the midquote prior to a

transaction executed at price p
In relative terms:
p−m
se ≡ d
m
The effective spread can be seen as a measure of a transaction’s impact on the
price (slippage)
Only available to individuals traders, but not the econometrician
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Measuring Liquidity: the realized spread
Quoted and effective spread adopt viewpoint of liquidity demander

Liquidity demanders costs is the dealers gain?
Example: Dealers buys share at 326$ when bid and ask are 326 and 327,
respectively,
Direct unwinding would lead to profit?
Only if prices don’t change! Assume prices go to 325.5 and 326.5 and market
maker sells at 326, no profit!
Coping with this problem: the realized half-spread: difference between the
transaction price and the midprice at some time ∆ after the transaction
Let pt be the price of the transaction at time t, the realized half-spread is then
given by
Sr = dt (pt − mt+∆ ) = dt (pt − mt ) − dt (mt+∆ − mt )
This can be seen as a measure of the profit earned by the dealer when he unwinds
a position at t + ∆
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Measuring Liquidity: the realized spread
Observe that
E (Sr ) = E (Se ) − E (dt (mt+∆ − mt ))
Average realized spread is smaller then the average effective spread if
E (dt (mt+∆ − mt )) > 0
i.e. if the change in the midprice following a transaction is positive

If the effective spread is small enough, liquidity provider would lose money
The value of the realized spread is sensitive to the choice of the reference
post-trade market price (i.e., tp mt+∆ )
Choice of ∆ depends on how quickly market participants adjust their quotes after
a transaction , i.e., on the transparency of the market
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Order Flow, Liquidity, and Securities Price Dynamics
Why and how do orders move prices?

Why is there a bid-ask spread?
How are prices formed when orders convey information?
What are the determinants of market liquidity?
What is inventory risk and how does it affect prices?
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Implication of the EMH: Martingale Property
EMH: The discounted stock price is a random walk/martingale

A stock price is always at the fair level (fundamental value)
⇒ Discounted stock price/gain process is a Martingale proces
A stock price reacts to news without delay
If the price must go up tomorrow - what would happen today?
The risk-adjusted likelihood of up-and down-movements of the discounted process are
equal
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EMH martingale property
Formally, the EMH states that
pt = µt = Et [v | Ωt ]
µt is the investors estimate of the security’s value

v is the fundamental value
Et [v | Ωt ] is the expected value of v conditional of information Ωt
here: ignore discounting
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The conditional expectation can only change when new information reaches the
market
Let the random variable t+1 = µt+1 − µt represent the investors revision induced
by the news that arrived from t to t + 1
News is new:
E (t s ) = 0 for s 6= t
E [t+1 | Ωt ] = 0
This implies
E [µt+1 | Ωt ] = µt
As pt = µt , it follows immediately
pt = Et (pt+1 | Ωt )
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Transaction prices follow a martingale: price changes over time are serially
uncorrelated:
∆pt+1 = pt+1 − pt = µt+1 − µt = t+1
so that
Cov (∆pt , ∆pt+1 ) = Cov (t , t+1 ) = 0
since
E (t s ) = 0 for s 6= t
Under EMH, prices changes are driven by new information, and asset prices
adjust immediately to the fundamental values given the available information.
Any change in price is due to completely unanticipated information
Previous price changes are uninformative
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How do markets become informational efficient?
What is the process whereby
pt = µt = Et [v | Ωt ]
comes to hold?
To answer this question we need to be more specific about the details of the trading
process
E.g., suppose the following:
(i) dealers are risk neutral and competitive
(ii) investors do not have more information than dealers
(iii) trading is cost free
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How do markets become informational efficient?
Assumption (ii) implies that t and the direction of trade indicator, dt , are
independent
Thus, dealers have no reason to update their information when they observe dt
Thus, the bid-ask spread must be zero
Consider how some dealer i sets his ask price at t, ati
He obtains an expected profit
E [(ati − v ) | Ωt ] = ati − µt
Thus the lowest value at which he is willing to sell is µt , which, due to

competition will be the price
Likewise, the highest price at which the dealer is willing to buy the asset (bid
price) is µt
Thus, all order are executed at µt , and any price movement is attributed to the
arrival of public information
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Challenges
Empirical challenge:
Intra-day volatility is too great to be explained solely by news
This suggests that the trading process itself is a source of volatility
We will now relax assumption (i)-(iii)
And, as we shall see, it will no longer be the case that the transaction price pt is
equal to the dealer’s valuation µt
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Informative order flow
Assume now that some trader’s know more than others

In such an environment, market participants will revise their estimate of security
values in light of order flows
E.g. high selling pressure will lead to a price decline
Idea of Jack Treynor (1971): the market maker attracts traders with superior
information, classic ”adverse selection”
Recall Akerlof (1970) on the market for lemons
Thus, the market maker must make profit with less informed agents
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Glosten Milgrom (1985)
Ask prices exceed the bid as the former is set in anticipation of receiving a buy order,
the latter a sell order:
at = Et [v | Ωt−1 , dt = +1]
bt = Et [v | Ωt−1 , dt = −1]
where Ωt−1 is all information available prior to observing dt
Idea: bid-ask spread arises because of informational content in dt
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Assume that an order at t is placed by an informed trader with probability π

and by a liquidity trader with probability (1 − π)
Liquidity trader buys and sells with probability 1/2
Assume the terminal value v has a binary distribution
v H with probability θt
v L with 1 − θt
vH > vL
Thus, the dealers estimate of vt before observing dt is
µt = θt v H + (1 − θt )v L
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buy
π Informed
sell The asset either takes the value v H
vH or v L , with probability θt and
buy
θt Liquidity (1 − θt ), respectively
sell
A trader is informed with
probability π and liquidity trader
with probability (1 − π)
An informed trader buys only good
buy
1 − θt π Informed assets
sell
vL
A liquidity trader buys with
buy probability 1/2
Liquidity
sell
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The bid and ask quotes set by competitive dealers will be
at = µ+
t = Et [v | Ωt−1 , dt = +1]
bt = µ−
t = Et [v | Ωt−1 , dt = −1]
where µ+ +
t and µt reflect the dealers valuation after observing dt .
−
Necessarily, µ+
t 6= µt and thus the bid ask spread must be positive, i.e.,
Et [v | Ωt−1 , dt = +1] > Et [v | Ωt−1 , dt = −1]
Why?
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Observe that the likelihood of a buy order is larger when v = v H

A buy order arises is two ways:
with probability 1 − π a liquidity trader arrives and buys with probability 1/2
with probability π an informed trader arrives and buys only if v = v H
Hence, if v = v H , the probability of a buy order is (1 − π)/2 + π

but if v = v L , its just (1 − π)/2
Logic: Buy orders are good news, sell order are bad news!
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Determinants of the bid-ask spread
The market maker must consider that he may be in one of two situations
(i) sell to an informed and lose at − v H , as informed investor buy only when v = v H
at t − 1, when setting the ask price, he assigns probability πθt−1 to an informed
investor buying
(ii) he may sell to a liquidity trader and book a profit of at − µt−1
conditional on trading with a liquidity trader, the dealers’s estimate of the final
value of the security remains unchanged at µt−1
The probability of meeting a liquidity trader is (1 − π)/2
Using the probabilities, we can write the dealer’s expected profit
θt−1 π(at − v H )) + 1/2(1 − π)(at − µt−1 ) + [(1 − θt−1 )π + 1/2(1 − π))] · 0

| {z } | {z } | {z }
profit with informed uninformed no buyer
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To build some intuition, consider the market maker that must choose the first bid and
ask of the day at t = 0, a1 , b1
Assume that this market maker estimates the security’s value at its unconditional
mean µ0 = (v H + v L )/2
his expected net profit is
1/2π(a1 − v H ) + 1/2(1 − π)(a1 − µ0 )
Assuming competitive dealer’s:
a1 = µ0 + π(v H − µ0 ) = µ0 + π/2(v H − v L )
| {z }
s1a
and the ask price includes a markup s1a

The bid is calculated correspondingly:
b1 = µ0 + π(v L − µ0 ) = µ0 − π/2(v H − v L )
| {z }
s1b
and the bid price is at a discount s1b

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Hence, the bid-ask spread for the first transaction will be
S1 ≡ a1 − b1 = π(v H − v L ),
where S1 is increasing in proportion of informed traders π and volatility (v H − v L )
Lets now consider a dealer’s problem later in the day

He will now set a competitive ask price of
πθt−1 πθt−1 (1 − θt−1 )

at = µt−1 + (v H −µt−1 ) = µt−1 + (v H − v L )
πθt−1 + (1 − π)1/2 πθt−1 + (1 − π)1/2
| {z }
sta
and the competitive bid:
πθt−1 (1 − θt−1 )
bt = µt−1 − (v H − v L )
π(1 − θt−1 ) + (1 − π)1/2
| {z }
stb
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Denoting by I the event of a buy order from an informed trader, U the arrival of a buy
order from an uninformed trader, and B the arrival of a buy order, the dealer’s
probability of trading with an informed trader on the buy side is
Pr[I ∩ B] Pr[I ∩ B] πθt−1

Pr[I | B] = = =
Pr[B] Pr[I ∩ B] + Pr[U ∩ B] πθt−1 + (1 − π)1/2
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We can obtain the bid-ask spread for any t
St ≡ at − bt = sta + stb

1 1
= πθt−1 (1 − θt−1 ) + (v H − v L )
πθt−1 + (1 − π)1/2 π(1 − θt−1 ) + (1 − π)1/2
Changes in π and (v H − v L )
Also changes in belief about fundamental θt−1 : spread low for θt−1 = 0 and
θt−1 = 0, highest for θt−1 = 1/2
What is the intuition?
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Bayes’s Rule
Conditional probability of event A given an event B is given by
Pr[A ∩ B] Pr[B|A] Pr[A]

Pr[A|B] = =
Pr[B] Pr[B]
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How are quotes revised?
So far, we had taken beliefs over µt−1 and θt−1 as given. let us now consider how
dealer’s revise their beliefs over time.
Define
θt+ ≡ Pr[v = v H | Ωt−1 , dt = +1]
θt− ≡ Pr[v = v H |Ωt−1 , dt = −1]
Bayes Rule: Let A be v = v H and B be the arrival of a buy order. Then
Pr[A] = θt−1 , Pr[B] = πθt−1 + (1 − π)1/2, Pr[B|A] = π + (1 − π)1/2
(1 + π)1/2
θt+ = θt−1
πθt−1 + (1 − π)1/2
and
(1 − π)1/2
θt− = θt−1
π(1 − θt−1 ) + (1 − π)1/2
Clearly, θt+ > θt− as a buy order conveys information that the asset is more valuable
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How are quotes revised?
Upon receiving a buy order at t, the dealer’s updated expectation of the security’s
value is the weighted average of v H and v L :
µ+ + H + L
t = θt v + (1 − θt )v
Recalling the dealers’ estimate before receiving the buy order was µt−1 , their revision
of the value in the wake of a buy order is:
µ+ + H + L H L
t − µt−1 = θt v + (1 − θt )v − [θt−1 v + (1 − θt−1 )v ]
πθt−1 (1 − θt−1 )
= [v H − v L ]
πθt−1 + (1 − π)1/2
| {z }
sta
and analogously in the wake of a sell order
µ− − H − L H L
t − µt−1 = θt v + (1 − θt )v − [θt−1 v + (1 − θt−1 )v ]
πθt−1 (1 − θt−1 )
=− [v H − v L ]
π(1 − θt−1 ) + (1 − π)1/2
| {z }
stb
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Price discovery
Buy order execute at the ask price, sell order at the bid, so the transaction price at t is
(
at = µ +
t if dt = +1
pt =
bt = µ−
t if dt = −1
Hence,
pt = µt = θt v H + (1 − θt )v L
where θt = θt+ if dt = +1 and θt = θt− if dt = −1

transaction prices reflect all available information to market makers at t
The semi-strong form EMH hold
All public information at t, the order flow observed Ωt = {d1 , d2 , ..., dt } is contained in
the price as
pt = µt = Et [v |Ωt ]
Surprising insofar as a positive bid-ask spread is typically seen as a friction and
symptom of inefficiency
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Price discovery
Can the strong form of the EMH hold in this setup? I.e. if informed traders learn
v = v H it must hold that p = v H
At first glance: impossible!
However, it depends on the price discovery (the process by which information is
incorporated into prices)
In the absence of informed trading, the order flow is balanced: 50 percent buy
and 50 percent sell
However, with informed trader the order flow is unbalanced and its tendency
provides information on the real value
The speed of learning is determined by how fast dealers become confident that
but or sell order make up more than 50 percent
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Price discovery
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Price discovery
A convenient way to express the updating of belief over θt is to look at the odds ratio
which yields a linear first-order difference equation
θt+ 1 + π θt−1
=
1 − θt+ 1 − π 1 − θt−1
θt− 1 − π θt−1
=
1− θt− 1 + π 1 − θt−1
Therefore, the odds ratio at time t is simply a function of the order imbalance xt
defined as the cumulative difference between buy and sell orders up to time t
xt
θt θ0 1+π θt−1

=
1 − θt 1 − θ0 1−π 1 − θt−1
where
t
X
xt = dτ
τ =1
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Price Movements and Volatility
Recall
µ+ a
t = µt−1 + st
µ− b
t = µt−1 − st
Or more compact:
µt = µt−1 + s(dt )dt
where (
sta if dt = +1
s(dt ) =
stb if dt = −1
Trade-to-trade changes in the transaction prices are correlated with the order flow
pt − pt−1 = µt − µt−1 = s(dt )dt
and the volatility is given by
var (∆pt ) = var (s(dt )dt )
Trading is a source of volatility

When dealer’s estimates become more accurate, volatility decreases
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Risk of losing to informed traders is not the only risk for market makers
In reality, processing a transaction costs
trading fees, clearing and settlement fees, paperwork and back office work, telephone
time, ...
Clearly, this may affect the bid-ask spread

Assume that dealers face a cost of γ per share, and thus:
at = µt−1 + γ + sta
bt = µt−1 − γ − sta
Hence,
St ≡ at − bt = 2γ + sta + stb
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As trades take place at bid and ask prices, the transaction price can be written as
pt = µt−1 + (s(dt ) + γ)dt
where again s(dt ) = sta if dt = +1 and s(dt ) = stb if dt = −1.

As µt = µt−1 + s(dt )dt , we obtain
pt = µt + γdt
The deviation is equal to the processing cost as the dealer tries to cover the cost by
executing at markups/discount. The price deviates from the fair value given all public
information
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Price Dynamics
Order-processing cost induce transient deviations of transaction prices as they do not

lead to a revision of dealers’ value expectation. To see this
Consider the arrival of a buy order at time t and define its short-term impact as
the deviation of the transaction price from immediately preceding fundamental
value µt−1
STimpact = pt − µt−1 = at − µt−1 = sta + γ > 0
Now consider the long-term impact, that is the impact on the average price in
some distant future t + T
E [pt+T | Ωt−1 , dt = 1] = E [µt+T | Ωt−1 , dt = 1] + γE [dt+T | Ωt−1 , dt = 1]

= µ
t +γE [dt+T | | Ωt−1 , dt = 1]
|{z}
µt−1 +s(dt )dt
= µt−1 + sta + γE [dt+T | Ωt−1 , dt = 1]
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Price dynamics
Moreover, assuming that the direction of trade today has no predictive power for its
direction in the future (as uncertainty about v has been resolved eventually), i.e.,
E [dt+T | Ωt−1 , dt = 1] = 0 we have that
E [pt+T | Ωt−1 , dt = 1] = µt−1 + sta
and thus the order processing has no long run impact.

We have that
STimpact − LTimpact = γ
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Another course of costs for the market maker is inventory risk

A dealer will always face temporary order imbalances (as this is the business
model)
This exposes the dealer to inventory risk: possibility of change in the value of his
holdings due to changes in the fundamental value of the underlying
Assuming that dealers are risk-averse they may require a risk premium as
compensation
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Assume that dealers are competitive and short-sighted: they assume that their
holding will be liquidated at the market price at t + 1
In pricing an order arriving at t, the dealer must take the fundamental risk from t
to t + 1 into account
That is, the risk that information t about the fundamental value of the security
µt may emerge
Assume the standard deviation of this risk is σ
Moreover, π = γ = 0
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Before trading at t, the representative dealer

Has cash ct
Staring inventory of the risky security zt
zt > 0 indicates long position
zt < 0 indicates short position
Marked to market, his initial wealth is wt
wt = p t z t + c t
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Assume the market is organized as a call auction and the dealer behaves competitively
Taking pt as given he chooses the number of shares he is willing to supply yt > 0
(ask)
and the an offer of how many shares he will buy yt < 0 (bid)
His inventory after selling yt shares is
zt+1 = zt − yt
and the corresponding cash position is
ct+1 = ct + pt yt
Thus, the dealer’s end of period profit is
wt+1 = pt+1 (zt − yt ) + ct + pt yt
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Price Dynamics with Inventory Risk: Two-Period Model
Let us start out with a simple two-period model in which the dealer must liquidate it
holdings at the fundamental value
v = µt +
Moreover, we assume that the dealer has mean-variance preferences:
U = Et (wt+1 ) − ρ/2vart (wt+1 )
Thus, a dealers objective is to
max{U = Et (v )(zt − yt ) + ct + pt yt − ρ/2(zt − yt )2 σ2 }

yt |{z}
µt
and the corresponding FOC:

∂U
= −µt + pt + ρ(zt − yt )σ2
∂yt
yielding an inverse supply function
pt = µt + ρσ2 (yt − zt )
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Dealer supply
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Dealer’s Supply
In equilibrium, the representative dealer must supply exactly the amount of shared
needed to satisfy the incoming order flow, yt = dt
Replacing this condition in the dealer’s supply function, we have that
pt = µt − ρσ2 zt +ρσ2 dt = mt + ρσ2 dt

| {z }
mt
Hence, the midquote reflects not only the stock’s expected fundamental value,
but also inventory risk adjustment
The ask price exceeds the midquote to reward the dealer for supplying one unit,
and the bid price incorporates a discount to reward him for adding one unit to his
inventory (
at = mt + ρσ2 if dt = +1
pt =
bt = mt − ρσ2 if dt = −1
The bid-ask spread is solely determined by the dealer’s risk aversion and the
volatility
St = 2ρσ2
64 / 122
Mean-standard deviation preferences
Before going to the multi-period analysis, lets use a more convenient type of preference
U = Et (wt+1 ) − ρsdt (wt+1 )
We have that
U = Et (v )(zt − yt ) + ct + pt yt − ρsdt (vzt+1 )
= µt (zt − yt ) + ct + pt yt − ρ|zt − yt |σ
Differentiating with respect to yt , we get

(
∂U pt − µt − ρσ if yt > zt , that is, zt+1 < 0
=
∂yt pt − µt + ρσ if yt < zt , that is, zt+1 > 0
That is, the change in utility from selling a share is the expected gain pt − µt minus
the implied risk ρσ
65 / 122
Equilibrium
∂U
If on balance ∂yt
> 0, dealers would like to sell infinitely many assets
∂U
In turn, if on balance ∂yt
< 0, they would like to buy infinitely many assets
Accordingly, in equilibrium. the price must be such that the dealer’s marginal
utility is equal to zero and the price must lie in the range
pt ∈ [µt − ρσ , µt + ρσ ]
Imposing the equilibrium condition yt = dt as before, we obtain the bid and ask prices
(
at = µt + ρσ if dt > zt , that is, zt+1 < 0
pt =
bt = µt − ρσ if dt < zt , that is, zt+1 > 0
Hence, the midquote is the fundamental value at t, mt = µt and the bid-ask spread
St = 2ρσ
66 / 122
Dealer supply
67 / 122
A Multi-period model
We can now consider a multi-period setting in which at each date t the future value of
dealer’s inventories is determined by their future price:
U = E (pt+1 )(zt − yt ) + ct + pt yt − ρ|zt − yt |sd(pt+1 )
Now: need to specify what determines order flow! For simplicity, suppose that the
order flow response to the prices is perfectly predictable:
customer will place buy order if mt < µt (dt = +1)
customer will place sell order if mt > µt (dt = −1)
no order if µt = mt
Maximization of the objective as well as the equilibrium condition give that
(
at = E [pt+1 ] + ρsdt (pt+1 ) if dt > zt , that is, zt+1 < 0
pt =
bt = E [pt+1 ] − ρsdt (pt+1 ) if dt < zt , that is, zt+1 > 0
68 / 122
Multi-period model
(
at = E [pt+1 ] + ρsdt (pt+1 ) if dt > zt , that is, zt+1 < 0
pt =
bt = E [pt+1 ] − ρsdt (pt+1 ) if dt < zt , that is, zt+1 > 0
The equilibrium price at t depends now on the expected value as well as the standard
deviation at t + 1, which in turn depend on the expectation and standard deviation at
t + 2,...
We need to find a stationary solution for the price
As in REE: a relationship between the economic variables such that there is
market clearing, and if correctly anticipated, it induces agents to behave
consistently
Recipe: guess relationship, verify for which parameters the guess is consistent
with the equilibrium and the expectations (method of undetermined coefficients)
Conjecture:
pt = µt − βzt+1 = µt − β(zt − yt )
for some β > 0
69 / 122
Multi-period model
Since in equilibrium yt = dt , this conjecture implies that bid and ask prices should be
at = µt − βzt + β
bt = µt − βzt − β
and the midquote

mt = µt − βzt
Intuitively, taken together with our assumption about the order flow’s response to
prices, the conjectured equilibrium relationship implies that upon increasing their
inventories from zt to zt+1 after filling a sell order (dt = −1), dealers will mark
down the current price pt
But to determine the magnitude of this price drop (β), we must consider that the
drop in pt will trigger a feedback effect: it will attract buy order from customers
in t + 1 and thus push pt+1 back up, i.e., inducing a reversion of the price
70 / 122
Multi-period model
Consider a scenario where the dealer has an inventory too large to be sold in one
deal, z > 1
Then, given mt = µt − βzt we should have mt < µt , triggering a buy order at
time t and reducing the inventory at t + 1 to zt+1 = z − 1
The same will occur in subsequent periods as long as the dealer’s inventory is
positive
It will stop at t + z when the inventory has been displaced
Thus, base on the conjecture pt = µt − β(zt − yt ), the expected value and the
variance of the price at t + 1 are
Et (pt+1 ) + µt − β(zt+1 − 1) vart (pt+1 ) = σ2
The conjecture implies that the expected price change is β, i.e., given that the
volatility is ρσ , we must have β = ρσ
71 / 122
Multi-period model
We thus have that

pt + µt − ρσ zt+1
and the equilibrium midquote
mt = µt − ρσ zt
Since in our example, the inventory decreases between t and t + z, the

equilibrium price must decrease at any time t + τ between t and t + z − 1, and
remain at the fundamental value once the inventory z is depleted
I.e., (
µt+τ − ρσ (z − τ − 1) for τ ∈ {0, 1, ..., z − 1}
pt+τ =
µt+τ for τ ≥ z
72 / 122
Full picture
73 / 122
Full picture
74 / 122
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2 Liquidity




75 / 122
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2 Liquidity




76 / 122
Price Formation with Informed Traders: Kyle (1985)
Kyle (1985) discusses price formation in a model with insider trading. In his proposed
setting, there are three types of agents:
Risk-neutral uninformed market makers
Uninformed liquidity traders / noise traders
Risk-neutral informed traders
Noise trader introduce noise such that perfect revelation of information becomes
impossible
Reminiscent of the Noisy Rational Expectation Equilibirum (NREE)
77 / 122
Kyle (1985): Setup
Asset and Agents:

There is an asset that has an ex-post value of v ∼ N(p0 , Σ0 )
Noise trader demand is a random mean-zero quantity, u ∼ N(0, σu2 )
Insider observes v and chooses demand x = X (v )
Informed trader chooses his demand x to maximize expected profit π given his
private information:
x = argmaxx E [(v − p)x |v ]
Risk-neutral market makers observe the total order flow, x + u, and set a price at
which they are willing to buy/sell this amount:
p = P(x + u) = E [v |x + u]
Timing
Stage 1: Insider and liquidity traders submit market orders
Stage 2: market maker sets the execution price
Repeated trading in the dynamic version of the model
78 / 122
Kyle (1985): Solving the model
Single informed trader: (Competitive) market maker:
Information: Information:
v = assets payoff X =x +u
Conjecture: pricing rule Conjecture: Insider trading rule
p = µ + λ(x + u) x = α + βv
No Updating Updating: E [v |x + u]
Optimal Demand: Price Setting Rule:
maxx E [(v − p)|v ]x p = E [v |x + u]

Cov [v ,x +u]
maxx E [v − µ − λx |v ]x p = E [v ]+ Var [x |u]
[x +u −E [x +u]]
µ 1 βΣ0
FOC: x = − 2λ + v p = p0 + [x + u − α − βE [v ]]
2λ β 2 Σ0 +σu2
Correct Beliefs: Correct Beliefs
µ 1 βΣ0
α = − 2λ ,β= µ = p0 martingale, λ =
2λ β 2 Σ0 +σu2
79 / 122
Calculations for Insider Trading Rule:
The objective of the insider it to maximize his profit
max E [(v − p)|v ]x

x
We conjecture that p = µ + λ(x + u) and his objective becomes:
max E [v − µ − λ(x + u)|v ]x

x
Given that E [u] = 0, we have
max vx − µx − λx 2
x
Taking the derivative with respect to x we arrive the first order condition
µ 1
x =− + v
2λ 2λ
80 / 122
Calculations for Price Setting Rule:
We start out with: p = E [v |x + u]. We can use the Projection Theorem and arrive at:
Cov [v , x + u]
p = E [v ] + [x + u − E [x + u]]
Var [x + u]
Observe that using x = α + βv and by Cov [v , βv ] = βCov [v ]:
Cov [v , x +u] = Cov [v , α+βv +u] = Cov [v , α]+Cov [v , βv ]+Cov [v , u] = βVar [v ] = βΣ0
Moreover,
Var [x + u] = Var [α + βv + u] = Var [α] + Var [βv ] + Var [u] = β 2 Σ0 + σu2
Therefore, we arrive at
βΣ0
p = p0 + [x + u − E [x + u]]
β 2 Σ0 + σu2
By using that x = α + βv and E [u] = 0, we have that
βΣ0
p = p0 + [x + u − α − βE [v ]]
β 2 Σ0 + σu2
81 / 122
Correct Beliefs
We had conjectured that: x = α + βv and p = µ + λ(x + u). Now, optimal individual

behavior given the conjectured behavior of the other agents is:
µ 1
x =− + v
2λ 2λ
and
βΣ0
p = p0 + [x + u − α − βE [v ]]
β 2 Σ0 + σu2
Observe that this implies:
µ = p0
µ
α = − 2λ ,
1
β= 2λ
βΣ0
λ= β 2 Σ0 +σu2
82 / 122
Dealer supply
where Σ0 = σv2
83 / 122
Price Formation with Informed Traders
One can solve for the four greeks and find
µ = p0 ,
12
σu2
β= ,
Σ0
− 12
σu2
λ = 1/2 ,
Σ0
and
12
σu2
α = −p0
Σ0
84 / 122
Kyle shows, that in equilibrium, the strategies of the insider and the market maker are
linear.
X (v ) = β(v − p0 )
P(x + u) = µ + λ(x + u)
where µ, β, and λ as above.

Properties:
The reciprocal of λ is a measure of market depth
Informativeness of the price is independent of the volatility of noise trading
p = µ + λ(x + u) = µ + λ(α + βv + u) = 1/2(v − p0 ) + λu
The insiders’s expected profit is the total expected loss of the noise traders
85 / 122
The expected profit of the insider is:

12
β 1 σu2
E [π|v ] = (v − p0 )2 = (v − p0 )2
2 2 Σ0
12
1 σu2 1 p
E [π] = Σ0 = σu Σ0
2 Σ0 2
The market depth is measured by 1

λ
= 2 √σu
Σ0
Order flow necessary to raise the price by $ 1
The loss per noise trader decreases as the number of noise traders rise
86 / 122
Dynamic Model
Kyle (1985) develops a continuous time version of the model and shows that λ
remains constant over time, while β increases and approaches infinity as the public
revelation of the information approaches.
Importantly, the insider does not trade aggressively

However, eventually, all private information enters the price.
87 / 122
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2 Liquidity




88 / 122
So far, we have assumed that competition among dealer’s results in zero expected
profits
We now consider a call auction in which each dealer submits a schedule of offers
that specifies a number of shares he is willing to buy or sell
Each dealer does not know the others dealers’ offers
An auctioneer then parcels out the aggregate demand, q, among the dealers
according to their demand or supply at the price that clears the market
89 / 122
Let Y k (p) be the total number of shares that dealer k is willing to supply at price
p
If Y k (p) > 0, the dealer is willing to sell shares
If Y k (p) < 0, the dealer is willing to buy |Y k (p)| shares
If there are K dealers, their overall supply at price p is given by

k=K
X
Y k (p)
k=1
Hence, when the aggregate demand for the security is q = x + u, the clearing
price p ∗ is given by
k=K
X
Y k (p ∗ ) = q
k=1
We will see that – unless K is very large – dealer profit will remain positive
90 / 122
In order to determine the optimal behavior of any dealer, we must specify his beliefs
about informed investor trading x and how that affects his estimate of the
security’s value based on total demand q
about the strategic behavior of his competitors and what that means for the
response of the equilibrium price to his own supply of the security.
Consider the following two conjectures
His best estimate given q is given by
E [v |q] = µ + λ̂q
Each dealer (including dealer k) will supply shares according to
Y k (p) = φ(p − µ)
91 / 122
The two conjectures together with the market clearing condition enable each
dealer k to identify a residual demand function
I.e., net customer demand q minus the supply from his K − 1 competitors for any
price p
He can then compute how the equilibrium price p ∗ (q) will respond to any
possible supply of shares y k he may decide on
This, in turn, allows to identify his profit-maximizing supply function
(best-response) Y k (p)
92 / 122
A rational expectation equilibrium of this model is a set of schedules {Y k (p)}K

k=1 for
the dealers a price mapping p ∗ (q) such that
(i) the schedule of offers posted by each dealer maximizes his expected profits, given
his beliefs about the security’s value and the price schedule chose by his
competitors
(ii) dealers correctly anticipate that the clearing price is given by p ∗ (q) and form
their beliefs accordingly
(iii) for each value of q, the market clears for p ∗ (q)
In this equilibrium, dealers’ expectations are rational in the sense that their beliefs are
based on the correct relationship between the clearing price and order flow q
93 / 122
Equilibrium
One can show that, if K ≥ 3, there is a rational expectation equilibrium in which
1 K −2
Y k (p) = (p − µ) ∀k ∈ {1, ..., K }
λ̂ (K − 1)
K
and the equilibrium price function is
p ∗ (q) = µ + λq
K −1 βΣ0
with λ = λ̂ K −2
and λ̂ = β 2 Σ0 +σu2
94 / 122
Equilibrium
Observe that if the number of dealers were infinite λ = λ̂ and the market depth is
entirely determined by the informativeness
In contrast, when the number of dealers is finite, λ is strictly larger than λ̂
The equilibrium price is given by
1 1
p = E [v |q] + λ̂q = µ + λ̂ + λ̂q
K −2 K −2
| {z }
markup
95 / 122
Market depth with imperfect competition
where λ̂ = α
96 / 122
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2 Liquidity




97 / 122
Limit Order Book Markets
So far we have looked at dealer market

A lot of trading in centralized markets occurs in continuous time via electronic
LOB
LOB market are different than dealership markets: no difference between market
makers and other agents
Any agent can carry out trades desired via limit order, market order or
combinations of the two
Liquidity provision depends on all agents
Unlike to call market which is a uniform auction where all traders involved in a
transaction receive the same price..
.. the limit order market has a discriminatory auction: all limit orders are
executed at their own posted price
98 / 122
A model of the LOB
Market environment:
Consider a risky security with final value
v =µ+
E () = 0
Period 0: agents post limit order
Period 1: market order executes against limit order
Period 2: value of security is realized
99 / 122
LOB
The limit orders are positioned on a price grid

The distance between two consecutive prices, the tick size, is denoted ∆
Denote by Aj the j th price on the grid above the expected value µ
And, Bj the j th price on the grid below µ
k=∞ as the set of bid prices, and to {A }k=∞ as the set of ask
We refer to {Bk }k=1 k k=1
prices
Let yk be the number of shares offered at price Ak and Yk be the cumulative
depth at price Ak
100 / 122
LOB
101 / 122
LOB
In period 1, a trader submits a market order of size q

A buy (sell) market order executes against sell (buy) limit orders until it is fully
served
The size of the market order is signed according to its direction
q < 0 for sell
q > 0 for buy
Suppose a trader submits a buy market order for q shares such that Y1 < q < Y2
His total payment is then Y1 A1 + (q − Y1 )A2
102 / 122
Market orders
The market order submitted can be buy or sell with equal probability
The size is unknown to the limit order traders in period 0
The probability distribution of the market order size is denoted by f (·) with cdf
F (·), where
1
f (q) = θe −θ|q|
2
1
The expected size of the market order E (|q|) = θ
103 / 122
LOB
At period 0, limit orders are submitted by a continuum of risk-neutral traders who

arrive sequentially
They fill up the book up to the point where there are no expected profit
opportunities
A competitive equilibrium is reached when
there is no price at which adding a limit order is profitable
there is no price at which cancelling a limit order is profitable
Furthermore: assume there is tie-breaking
Two limit orders at the same price are executed in the order in which they have been
submitted
For instance, the last share offered at price Ak executes if and only if the next market
order is a buy order that exceeds the number of shares offered up to price Ak , that is
q > Yk
Hence, the execution probability of the marginal share offered at price Ak is
P(Yk ) ≡ Pr[q ≥ Yk ] = 1 − F (Yk )
The execution probability of Bk is determined in the same way
104 / 122
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2 Liquidity




105 / 122
Consider the following setup

No trader has private information
Market orders are exogenous
Competing traders place limit order at a display cost of C per share
We derive the equilibrium by analyzing the zero-profit condition
We write the expected profit on the marginal unit offered at price Ak when the
cumulative depth at this price is Yk
In case of execution, the realized profit on the marginal unit is Ak − v − C
In case of no execution it is: −C
Hence, the expected profit is
Πk (Yk ) = P(Yk )[Ak − E [v |q ≥ Yk ]] − C
As a market order contains no information, the order flow is independent of the

security value, i.e., E [v |q ≥ Yk ] = E [v ] = µ
Πk = P(Yk )(Ak − µ) − C
The probability of execution for a sell limit order cannot be greater than 1/2
Hence, the expected profit on a marginal limit order at an ask price below
2C + µ ≡ A∗ is negative, and hence no sell limit order below A∗
106 / 122
Zero-profit condition
The no-entry/exit condition for a competitive equilibrium holds when
Πk (Yk ) = 0
implying
C C
P(Yk ) = ⇔ Ak = µ +
Ak − µ P(Yk )
Recalling that P(Yk ) = 12 e −θYk , we can derive the cumulative depth at price
Ak ≥ A∗ = 2C + µ
1 Ak − µ

Yk = ln
θ 2C
Cumulative depth
increases with 1/θ, average order size (anticipate that ”the queue goes faster”)
decreasing in display cost C
107 / 122
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2 Liquidity




108 / 122
Glosten 94 model
How does adverse selection affect the LOB?

Assume market order are submitted by either uninformed traders or by informed
traders
Informed traders know the true value of the security v = µ +
Recall the expected profit on the marginal unit offered at price Ak
Πk (Yk ) = P(Yk )(Ak − E (v |q ≥ Yk )) − C
where E [v |q ≥ Yk ] is the estimate of the security value conditional on the

execution of the marginal unit at price Ak
Intuitively, with informed trading, this upper tail expectation increases with Yk
Consider an informed trader’s optimal strategy, given v ≥ Ak
If not wealth constrained, his demand is unlimited at any price below v
An uninformed trader, in contrast, only hits the limit order needed to fill her desired
order
Thus, as the queue of limit order at price Ak lengthens, it becomes more likely that the
market order triggering the marginal order is from an informed trader that know that
v > Ak
Hence, the marginal trader’s valuation conditional on execution gets larger as Yk
increases
109 / 122
Example
Lets illustrate that the upper tail expectation increases with Yk

Assume final value of security is either v L = µ − σ or v H = µ + σ, with equal
probability
Market order is either informed with probability π or uninformed with probability
1−π
Uninformed traders are buyers or sellers with equal probability
Desired trade size is either small qS or large qL with probabilities φ and 1 − φ,
respectively
Let A(qS ) and A(qL ) be the ask prices at which cumulative depth on the ask side
is qS and qL , respectively
Assume A(qL ) < v H
Hence, if the informed investors know that the value is high, the sweeps all limit
orders up to price A(qL )
110 / 122
Example (ctd)
Let I and U denote the event that the market order is submitted by the informed
and the uninformed traders, respectively
π
2
Pr[I|q ≥ Y ] = = π for Y ≤ qS
π
2
+ 1−π
2
and
π
2 π
Pr[I|q ≥ Y ] = (1−π)(1−φ)
= for qS < Y ≤ qL
π
+ π + (1 − π)(1 − φ)
2 2
The second expression is greater than the first: a trade no larger than qS conveys
no information about the identity of the person submitting the trader
However, a trader larger than qS is more likely to come from an informed trader
Notice that
E [v |q ≥ Y ] = Pr[U|q ≥ Y ]µ + Pr[I|q ≥ Y ](µ + σ) = µ + Pr[I|q ≥ Y ]σ
Hence, E [v |q ≥ Y ] is weakly increasing in Y , because a limit order far back in

the queue is more likely to be hit by an informed trader
111 / 122
Equilibrium LOB
Let us now analyze the equilibrium LOB

A competitive equilibrium is obtained when cumulative depth Yk at each price Yk
is such that the following holds:
Πk (Yk ) = 0 if Πk (Yk−1 ) > 0, and Yk = Yk−1 if Πk (Yk−1 ) ≤ 0
i.e., the marginal unit must yield no profit if offering less were to yield positive
profits
This implies:
C
Ak = E [v |q ≥ Yk ] + ifYk > Yk−1
P(Yk )
C
Ak < E [v |q ≥ Yk−1 ] + ifYk = Yk−1
P(Yk−1 )
112 / 122
Equilibrium LOB
Assume again f (q) = 12 θe −θ|q| and assume C = 0

Further, assume that the expected value of the security conditional on the market
order size is linear
E [v |q = x ] = µ + λx
This is comparable to an updating rule
specifies how limit order traders update their estimate of the asset if they knew the
total size of the market order
The parameter λ is a measure of the informativeness of the market order
Using the law of iterated expectations and the updating rule, we obtain
E [v |q ≥ x ] = E [E [v |q = x ]|q ≥ x ]
= µ + λE [q|q ≥ x ]
R∞
qθe −θq dq
= µ + λ Rx ∞
θe −θq dq
x
λ
=µ+ + λx , for x ≥ 0
θ
113 / 122
Equilibirum LOB
Asusme tick size was zero, the equilibrium price schedule on the ask side of the
book is
λ
A(Y ) = E [v |q ≥ Y ] = µ + + λY
θ
If the tick size was non-zero, we have that
λ
Yk = 0 for Ak ≤ µ +
θ
λ
Ak − (µ + θ
) λ
Yk = for Ak > µ +
λ θ
114 / 122
Some important properties
The limit order market features a non-zero bid-ask spread also for very small orders
This feature is not an effect of the tick size, it persist when the tick is zero, i.e.,
2λ
A(0) − B(0) = >0
θ
This property was not in the Kyle model
Unlike in a call auction, liquidity suppliers cannot make their quotes contingent
on the total size of the market order
Limit orders at the top of the book are more exposed to adverse selection
Consider the most competitive sell limit order
Offer can be hit by a very small order, conveying very little information
Offer can be hit by a very large order, strongly informative
The depth of the LOB is decreasing in the informativeness of the order flow
A λ increases, the LOB thins out: the more informative the order flow, the more
exposed the liquidity suppliers are to adverse selection
115 / 122
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2 Liquidity




116 / 122
A recurrent theme so far was the cost of liquidity provision, wedge between
fundamental value of an asset and its transaction price
Can liquidity affect an asset’s value?
First, transaction costs reduce the return to investors, as a tax on capital gains does.
Hence, investors pay less for less liquid assets
Second, liquidity risk varies over time and the fluctuations may add liquidity risk to the
basic risks characterizing financial assets
Finally, we need to ask, why can’t arbitrageurs play on the differences in prices
and returns generated by differences in liquidity?
117 / 122
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2 Liquidity




118 / 122
The illiquidity premium
Treasury bills and treasury notes have the exact same default risk, but notes are
typically traded at a discount
Why? The treasury bills market is more liquid than the notes market
Consider the following simple model:

an investor plans to hold a security for h periods
the bid-ask spread at date t is given by st
the midquote is the fundamental value µt
st

at = µ t 1+
2
st

bt = µt 1−
2
119 / 122
Suppose the investor requires a return r on the security

The maximum price the investor is willing to pay is:
bt+h
at =
(1 + r )h
And hence,
st st+h 1

µt 1+ = µt+h 1 −
2 2 (1 + r )h
Hence, we can express the current value of the assets as its discounted future value
adjusted for current and future transaction costs
s
1 1 − t+h
2
µt = µt+h
(1 + r )h 1 + s2t
The last term is a measure of illiquidity, decreasing in both st and st+h .

Rewriting, we get
s
µt+h 1 − t+h
2
= (1 + R)h = (1 + r )h
µt 1 + s2t
Allowing for the approximation
R ' r + s/h
120 / 122
Recall the CAPM:

E (rj ) = r + βj [E (rM ) − r ]
where E (·) is the expectation operator

rM is the uncertain return of the market portfolio
and βj ≡ cov (rj , rM )/var (rM )
For asset j, we then have

st+h
1− 2
(1 + E (Rj ))h = (1 + E (rj ))h
1 + s2t
Or, given our approximation
E (Rj ) = r + sj /h + βj (E (rM ) − r )
121 / 122
122 / 122

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Market Microstructure and Market Making

September 17, 2018

1 Institutions and Some Terminology

3 Order Flow, Liquidity, and Securities Price Dynamics

4 Trade Size and Market Depth

5 Limit Order Book Markets

6 Liquidity and Asset Pricing

1 Institutions and Some Terminology

3 Order Flow, Liquidity, and Securities Price Dynamics

4 Trade Size and Market Depth

5 Limit Order Book Markets

6 Liquidity and Asset Pricing

A trading mechanism defines the ”rules of the game”

Possible rules can be put together in a virtually boundless number of combination

Orders represent various mechanisms for executing transactions

Limit order markets

NYSE: floor brokers, monopolistic specialist, LOB

Matching only at discrete points in time

Exchanges that emerged from informal trading

1 Institutions and Some Terminology

3 Order Flow, Liquidity, and Securities Price Dynamics

4 Trade Size and Market Depth

5 Limit Order Book Markets

6 Liquidity and Asset Pricing

If the structure of a securities market is compared to car design, measuring liquidity

S(q) = ā(q) − b̄(q)

The relative-weighted average bid-ask spread is

where d ∈ {−1, 1} is the order direction, and m the midquote prior to a

Quoted and effective spread adopt viewpoint of liquidity demander

Average realized spread is smaller then the average effective spread if

E (dt (mt+∆ − mt )) > 0

i.e. if the change in the midprice following a transaction is positive

1 Institutions and Some Terminology

3 Order Flow, Liquidity, and Securities Price Dynamics

4 Trade Size and Market Depth

5 Limit Order Book Markets

6 Liquidity and Asset Pricing

Why and how do orders move prices?

EMH: The discounted stock price is a random walk/martingale

Formally, the EMH states that

µt is the investors estimate of the security’s value

What is the process whereby

Thus the lowest value at which he is willing to sell is µt , which, due to

1 Institutions and Some Terminology

3 Order Flow, Liquidity, and Securities Price Dynamics

4 Trade Size and Market Depth

5 Limit Order Book Markets

6 Liquidity and Asset Pricing

Assume now that some trader’s know more than others

where Ωt−1 is all information available prior to observing dt

Idea: bid-ask spread arises because of informational content in dt

Assume that an order at t is placed by an informed trader with probability π

Thus, the dealers estimate of vt before observing dt is

The bid and ask quotes set by competitive dealers will be

Et [v | Ωt−1 , dt = +1] > Et [v | Ωt−1 , dt = −1]

Observe that the likelihood of a buy order is larger when v = v H

Hence, if v = v H , the probability of a buy order is (1 − π)/2 + π

θt−1 π(at − v H )) + 1/2(1 − π)(at − µt−1 ) + [(1 − θt−1 )π + 1/2(1 − π))] · 0

1/2π(a1 − v H ) + 1/2(1 − π)(a1 − µ0 )

Assuming competitive dealer’s:

and the ask price includes a markup s1a

and the bid price is at a discount s1b

Hence, the bid-ask spread for the first transaction will be

max{U = Et (v )(zt − yt ) + ct + pt yt − ρ/2(zt − yt )2 σ2 }

pt = µt − ρσ2 zt +ρσ2 dt = mt + ρσ2 dt

= µt (zt − yt ) + ct + pt yt − ρ|zt − yt |σ

pt ∈ [µt − ρσ , µt + ρσ ]

Et (pt+1 ) + µt − β(zt+1 − 1) vart (pt+1 ) = σ2