1 Int Introduction 1.1 Scope of the Book - Market Microstructure o Branch of nancial economics that investigates trading and the organization of markets o Field has substantially grown in size and importance since 198 crash 1.2 Objectives 1.3 Ins Instrum trume ents and Marke rkets ! "nstruments o #ommon stocks$ preferred stocks$ bonds$ convertible bonds$ warrants$ options$ futures contracts$ forward contracts$ foreign e%change contracts$ swaps$ reinsurance contracts$ commodities$ pollution credits$ water rights$ and even many betting contracts$ etc o &sed to e%amine organized trading ! Markets o 'he place where where traders gather gather to trade instruments instruments (hysical trading )oor *+,#hicago Mercantile -%change -uro*e%t .msterdam /ptions -%change -lectronic -lectronic system where traders can easily communicate with each other *asda0 -uro*e%t ong 2ong Futures -%change "nterbank foreign e%change market 1.4 Brie Brieff Over Overvie vie! ! of of "rad "radin# in# and $%chan $%chan#e #es s - 3uantities 'raders have to nd enough people people willing willing to trade with them o 'raders - ,izes see 43uantities5 o - 6ealers 'rade with their their clients when when their clients want to trade o 'rade - Bid o (rice at which dealer will buy from clients - .sk o (rice at which dealer will sell to clients - Brokers .gents who arrange trades for their clients o o elp clients nd traders willing to trade with them (rot by charging commissions o - ,peculators 'raders who trade to prot prot from information information they they have about future future o 'raders prices - 7ell!informed speculators o .ble to predict futures prices better than other traders #hoose to buy or sell based upon which side they e%pect will prot o o /ften beat dealers
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Bluers (eople who fool uninformed traders into trading unwisely o .ble to prot if price impacts of their buying and selling are not e%actly o opposite to each other ero!sum game ,omeone can win only if somebody else loses o "nvestors o &se the markets to move money from the present to the future Borrowers o &se markets to move money from future to present o /pposite of investor edgers o 'rade to manage nancial risks they face .sset e%changers o 'rade one asset for another they value more :amblers o 'rade to entertain themselves .rbitrageurs o -nsure that prices do not vary much across markets o 7hen prices diverge$ they buy in cheaper markets and sell in more e%pense markets o #onnect sellers in cheaper markets to buyers in more e%pensive markets Fungible o "f one unit ;a share$ bond$ contract$ etc< of the instrument is economically indistinguishable from all other units o -asier to trade since buyers don=t care which units they receive$ and will buy best price$ and sellers can sell to any buyer o -asier to trade that instruments with idiosyncratic characteristics o "n derivative markets$ cause trading to concentrate in >ust a few standardized contracts 'e( )ecurrent "hemes "nformation .symmetries o 'raders who know more about values and traders who know more about what other traders intend to do have a great advantage over those who do not 7ell!informed traders prot at the e%pense of less!informed traders o /ptions o 'he option to trade (eople who write limit orders give free trading options to other traders o -%ternalities positive e%ternalities o created when people do something that benets other people without compensation negative e%ternalities o created when people do something that harms other people without penalty order )ow e%ternality
most important e%ternality in market microstructure traders who oer to trade give other traders valuable options to trade for which the oerers are not compensated attracts and binds traders to markets because they want to benet from free trading options market structure consists of the trading rules$ the physical layout$ the information o presentation systems$ and the information communication systems of a market determines what traders can do and what they can know o aects trader strategies$ the power relationships among dierent types o of traders$ and ultimately trader protability #ompetition with free entry and e%it o 'raders compete in markets to make prots ,trategies with strategies generating large prots attract traders o o ,trategies that are unprotable are abandoned -nsures alternative trading strategies produce e0ual net prots$ on o average$ after accounting for all costs #ommunications and computing technologies o Markets are information processing mechanisms (rocess information about who wants to trade$ how much$ and at what prices ?esulting prices aggregate information about fundamental values (rice correlations Markets for similar instruments are closely related o o 'end to have similar conditions and compete ercely with each other for order )ow (rincipal!agent problems .rise when agents do what they want rather than what their principals o want them to do "nvolves brokers and clients o Brokers won=t always do what you want them to ;may not work as hard as you want them to< 'rustworthy o (eople who try to do what they say they will do #reditworthy o (eople who can do what they say they will do ero!,um game o .ccounting gains by one side must e0ual the losses suered by the other side Out+ine of the Book Bull markets ?isking markets o o Bull use horns to thrust upwards Bear markets o Falling markets Bears strike downward with claws o o
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n Important isc+aimer Summar( &nderstand theory and practice of trading in e%change markets and dealer networks ! Markets have changed substantially the last 1@@ years$ and will continue to for the ne%t 1@@ ! #urrent pace of change is fast$ and accelerating ! -conomic principles governing markets and traders$ however$ will not 2 "radin# Stories 2.1 )etai+ "rade in an /0S$-isted Stock - Market order "nstructs broker to buy at the best price available o - Aimit order o "nstructs broker to buy at the best price possible$ but in no event pay more than limit price "nclude when order e%pires o - Aimit price o (rice at which buyer instructs broker to not go above when buying - 6ay order o /rder that will e%pire when the day trading session ends 2.2 )etai+ "rade in a /asda Stock 2.3 n Institutiona+ "rade in a /0S$ Stock 2.4 n Institutiona+ "rade in a /asda Stock 2.& er( ar#e B+ock Stock "rade 2.* Some ash ommodit( and ssociated 5utures Market "rades - -%change for physical o
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2., n Options Market "rade 2. Bond Market "rade 2.6 5orei#n $%chan#e "rade 3 "he "radin# Industr( 3.1 7ho re the 8+a(ers9 - 'raders (eople who trade o o .rrange their own trades$ have other arrange trades for them$ or arrange trades for others - (roprietary traders (eople who trade for their own accounts o - Brokers (eople who arrange trades as agents for their clients o - .gency traders ,ee 4Brokers5 o - #ommission traders o ,ee 4Brokers5 - #ommission merchants o ,ee 4Brokers5 - (roprietary trading
'rading done by proprietary traders - .gency trading o 'rading done by brokers - Aong positions 7hen traders own something o o (rot when prices rise Buy low sell high o - ,hort positions 7hen traders have sold something that they don=t own o o ope prices will fall so they can repurchase at lower price to cover their position - #over their positions 7hen traders short a stock$ then buy back at a lower price to return o borrowed stock - ,hort sellers o 'raders who short stocks ,ell high buy low o - Buy side o 'raders who buy e%change services - Ai0uidity o .bility to trade when you want to trade Most important service o - ,ell side o 'raders who sell li0uidity to the buy side 3.1.1 "he Bu( Side - "nvestment sponsors Buy!side institutions such as pension funds$ mutual funds$ trusts$ o endowments$ and foundations that invest money - "nvestment advisors o (eople who manage investment sponsors - "nvestment counselors ,ee 4"nvestment advisors5 o - "nvestment managers ,ee 4"nvestment advisors5 o - (ortfolio managers ,ee 4"nvestment advisors5 o - Buy side traders o 'raders employed by investment advisors who e%ecute trading decisions - Beneciaries (eople who benet from investment sponsors o 3.1.2 "he Se++ Side - ,ell side o ,ide of the trading industry that includes dealers and brokers who provide e%change services to the buy side o elp buy!side traders trade when they want to - 6ealers o
(eople who accommodate trades that their clients want to make by trading with them when their clients want to trade o (rot when they buy low and sell high - Brokers o (eople who trade on behalf of their clients .rrange trades that their clients want to make by nding other traders o who will trade with their clients (rot when their clients pay them commissions for arranging trades o - Broker!dealers o 'raders who both deal and broker trades - 6ual traders ,ee 4Broker!dealers5 o - 7irehouses o Aarge broker!dealers ?efers to the telegraph o Broker!dealers who used telegraph collect orders from branch oces in distant cities were able to e%pand businesses substantially and greatly increase prot .bility to communicate 0uickly was$ and IS$ very important in the o trading industry 3.2 "rade 5aci+itators 3.2.1 $%chan#es - -%changes (rovide forums where traders meet to arrange trades o - /rder!driven trading systems -%changes that arrange trades by matching buy and sell orders o according to a set of rules /ften use computers$ clerks$ or member!traders to process orders o o -ssentially brokerages ;arrange trades for their clients< - -lectronic communications network o /rder!driven trading systems that are not regulated as e%changes May be owned by brokerages$ dealers$ or other entities o o Most importantC "sland -#*$ "nstinet$ ?-6"Book$ .rchipelago$ Bloomberg 'radebook o Most in process of registering to become e%changes - /ver!the!counter o 'rading that does not take place at e%changes 3.2.2 +earin# and Sett+ement #ents: epositories: and ustodians - #learing .gents o #learing agent Matches buyer and seller records and conrms that both traders agreed to the same terms *ational ,ecurities #learing #orporation o Aargest securities clearing agency in the &, #lears o 7hen a buyer and seller both report that they traded with each other$ and reported terms of trade are identical o /ut!trades o
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7hen records do not match e%actly$ and the clearing agent reports discrepancies to the traders$ who have to resolve them 6on=t 2now o ,ee 4/ut!trades5 ,ettlement .gents ;middlemen< -scrow agents o ,ettlement agents in the real estate markets o *et settlement For each client$ the settlement agent nets the buys and sells in each security to a single net security position *ormal!way settlement o /ccurs three business days after trades are arranged o 'DE ,ee 4*ormal!way settlement5 #ash settlement o ,pecial settlement instruction which occurs on the day of the trade #learinghouses o #learinghouses #lear and settle all trades in derivative contracts &sually guarantee that both parties will perform on their contracts .ct as buyer for every seller and seller for every buyer .re the issuers and guarantors of their contracts :enerally owned by clearing members o #learing members #learinghouse owners who are >ointly responsible for settling all trades o Margins #ollateral re0uired by clearinghouses to secure their obligations$ provide timely information about their nancial conditions and their trading activities$ and not e%ceed positions limits that the clearinghouse establishes for them o ariation margin -nsure that the incentives to default on a contract do not grow as prices move against a losing position o ,traddle 7hen a trader holds positions in two dierent types of instruments ?isks oset each other so that combined position is less risky than either position held alone #onsists of a position in a put and an osetting position in a call o 'echnically bankrupt 7hen traders no longer have enough wealth to settle their trades "f positions don=t change$ traders actually become bankrupt
Brazilian straddle /ften used when traders know that they are technically bankrupt and have nothing to lose Massively increase positions$ so that if price changes$ they can escape nancial problemsG "f prices change against them$ those who guarantee their trades suer the losses - 6epositories and #ustodians old cash and securities on behalf of clients elp settle trades by 0uickly delivering cash and security certicates elp ensure security of clients= assets o 6epository 'rust #ompany Aargest depository in the world ,traight!through processing o 'rading systems that fully automate the clearing and settlement process #heap and minimizes potential for error 3.3 "radin# Instruments - 'rading "nstruments ,ecurities$ contracts$ commodities$ and currencies that traders trade o "ncludeC real assets$ nancial assets$ derivative contracts$ insurance contracts$ and gambling contracts - Financial "nstruments o "nclude nancial assets$ derivative contracts$ and insurance contracts 3.3.1 )ea+ ssets - ?eal assets o "nclude physical commodities$ real estate$ machines$ patents$ and other ntellectual properties "nclude pollution credits o o .ppear only on assets section of B, - (ollution credits ?ight to emit a specied 0uantity of a given pollution o 3.3.2 5inancia+ ssets - Financial assets o "nstruments that represent ownership of real assets and the cash )ows they produce o ,tocks and bonds ;represent ownership of the assets of a corp< "nclude currencies warehouse receipts$ and trust units o - "ssuers #reators of all nancial assets o #orporations issue stocks$ bonds$and warrants :overnments issue currencies and bonds 7arehouses issue commodity receipts 'rusts issue trust units ! (rimary markets o 7here issuers rst create and sell issues ! ,econdary markets o ,ubse0uent trading of issues after rst sold o
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*ew issues o *ewly issued issues ! ,easoned securities o "ssues after being initially issued ! "(/ o 7here primary trading in new e0uity issues happens ! &nderwriters elp issuers sell their securities o o Broker!dealers at "Bs who nd buyers for securities #harge issuers fees for their services o ! Best eorts oering o &nderwriter acts strictly as a broker ! &nderwritten oering o &nderwriter guarantees the issuer an oering price ! Fi%ed!price open oering o &nderwriter sets a price and buyers subscribe to the oering "f oversubscribed$ underwriter conducts a lottery to allocate shares ! ,pot markets o Markets where commodities and currencies trade for immediate delivery ! Forward markets o Market where commodities and currencies trade for future deverly ! Futures markets o ,ee 4Forward markets5 3.3.2.1 e;nitions of Some ommon 5inancia+ ssets - -0uities o ,tocks ?epresent ownership of corporate assets$ net of corporate liabilities alue depends on corporate asets$ liabilities$ and income 6epend on how well traders e%pect corporate managers will use corp assets in the future (referred stocks o ,tocks that pay diviends at contractually specic rates Must pay all accrued dividends on preferred stocks before paying any dividends on common stock .merican depository receipts o 'rust units that traders use to trade foreign stocks in &, markets -ach trust holds only the stock of a single foreign company .llow traders to avoid international settlement problems -%change traded funds o Mutual funds that trade at e%changes Mostly inde% funds trying to mimic returns of a market or industry inde% ?east estate investment trusts o 'rusts that own real estate
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,ecuritize real estate to allow investors and speculators to trade real estate interests like common stock shares ,ecuritizing o .llows investors and speculators to trade real estate interests like common stock shares 6ebt "nstruments Bonds o 6ebt securities issued by corporations$ governments$ and occasionally individuals #reated when debtors borrow money alue depends on interest rates$ issuer creditworthiness$ assets pledged as collateral$ and attached options /ften 0uoted as percentage of par value ,traight bond o Bond that pays interest periodically until it matures .t maturity$ issuer redeems bond for principal value (rincipal o (rice at which issuer redeems bond Face value o ,ee 4(rincipal5 #redit 0uality o (robability that a bond issuer will make all bond payments when they are due "nvestment grade bonds o Bonds that are e%pected to make all interest and principal payments on time o Hunk bonds Bonds with less certain interest and principal payments igh yield bonds o ,ee 4>unk bonds5 "nvestors re0uire high yields to compensate for probability that issuers will default on their payments #redit 0uality depends on nancial strength of its issuer and upon that collateral and bond covenants that the issuer uses to secur the bond o 'reasury bills 6ebt securities issued by a country Mature in one year or less 6on=t pay interest ,ell at discount from face value o 'reasury notes ,ee 4'reasury bills5 Mature in I!J years o 'reasury bonds ,ee 4'reasury bills5 Mature ten or more years after issued ero coupon bonds o
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Bonds that pay no interest ,imply return their principal value at maturity Buyers only buy if at a discount from face value (ure discount bonds ,ee 4ero #oupon bonds5 Fi%ed income arbitrageurs Hump into action when zero!coupon bonds desired more than available Buy straight bonds and clip the coupons Bundle coupons by interest payment dates and sell bundles and remaining nal principal payments as zero coupon bonds #lip 'ake coupons from straight bonds ,tripping a bond 7hen %ed!income arbitrageurs create zero!coupon bonds by buying straight bonds and clipping the coupons$ bundling them$ and selling the bundles and principal payments Bearer bonds Bonds owned by whoever bears them *ot registered with bond issuers #ommercial paper ,hort!term debt security issued by a corporation &sually matures in nine months or less from the date it=s issued Mortgage!backed securities Bondlike instruments which receive the mortgage payments that borrowers make on their mortgages Back by specied set of mortgages called a mortgage pool Mortgage pool ,pecied set of mortgages that back a security (ass!through securities MB, is an e%ample since they receive mortgage payments as they are paid #ollateralized mortgage obligations Mortgage!backed securities that divide rights to the cash )ows from the mortgage pool into several dierent tranches -ach tranche has a dierent rights to the payments that the mortgage borrowers make :enerally structured to look like various types of bonds ?eal estate mortgage investment conduits ,ee 4#M/s5 Fi%ed income products .ll debt instruments 'o%ic waste ?iskiest #M/ tranches *o one wants to hold them ,ell at huge discounts 7orthless if too many defaults
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igh returns if few defaults 3.3.3 erivative ontracts - 6erivative contracts "nstruments that derive their values from the values of underlying o instruments upon which they are based - &nderlying instruments o "nstruments on which derivative contracts are based - ero net supply o ,um of all long positions minus sum of all short positions is always zero since sellers create derivative contracts when they rst sell them - Futurity alues of derivatives depend on future events o - -%piration date o 6ate when traders make nal settlement and contract e%pires - -%piry o ,ee 4-%piration date5 For -uropeans o - "nnitely lived #ontracts that do not e%pire o o *o successful ones yet - (hysically settled contract ?e0uires seller deliver underlying instrument to buyer when obligated o to do so o Buyer pays cash for the instrument at the agreed price - #ash!settled contract ?e0uired the seller to deliver cash value of the underlying instrument o to the buyer when obligated to do so o Buyer pays agreed!upon purchase price "n practice$ buyer pays dierence between value and price o - *otional size o For physically delivered contracts o 'he amount the seller must deliver - *otional value For cash!settled contracts o o Formula specied value that determines nal cash settlement - arational margin payments o 'ransfer money from buyers to sellers or from sellers to buyers to ad>ust the prices of their contracts to re)ect current market conditions o -nsures contract values don=t change as market conditions change ?educe the chance that traders will default when contracts e%pire o 3.3.3.1 Some erivative ontract e;nitions - Forward contracts #ontracts for the future sale of some commodity o - ,tandardized futures contract Forward contracts that an e%change clearinghouse guarantees o 6oesn=t matter whether other traders are creditworthy$ >ust o clearinghouses - /ption
?ight to do something /ption contract :ives holders the option to buy or sell an underlying instrument at a o %ed price 7riter o 'rader who sold the contract 7ritten upon &nderlying instrument #all option /ption to buy at a %ed strike price o ,trike price (rice at which holder can e%ercise its option o (ut option /ption to sell at a %ed strike price o -%piration date o 6ate before which an option holder can e%ercise the option .merican!style option o /ption holder can e%ercise option any time before e%piration date -uropean!style option o /ption holder can only e%ercise on the e%piration date 6erivative contracts /ption contracts depend on underlying security values o Futures option contract /ption contract written on a futures contract o o older of call option on futures contract has the right to purchase a futures contract at a specied price o 'rade at e%change where underlying futures contracts trade ,waps o #ontracts for the e%change of two future cash )ows #ash )ow ,eries of payments o "nterest rate swap (rovides for the e%change of a future series of %ed!rate income o payments for a future series of variable )oating!rate interest payments #urrency swap o (rovides for the e%change of a future series of %ed payments in one currency for a future series of payments in another currency 6erivative contracts alues of contracts depend on values of cash )ows that traders swap o ,waptions /ptions on a swap contract o o 'rader who owns a swaption call has the right to buy a swap at the specied strike price ,waps yield curve o
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3.3.4 Insurance ontracts and
(eople who are concerned about the loss that they would e%perience if some future event takes place - :ambling contracts ,ee 4"nsurance contracts5 o o .rranged by people for entertainment - edgers (eople who buy insurance contracts o 3.3.& =(brid ontracts - -0uity warrant - 7arrants /ptions that allow the holder to purchase stock at a specied price o from the issuing corporation at some time in the future - #onvertible bonds older can e%change bond for stock under some circumstances o #ombination of straight bond plus an option to e%change the bond for o stock 3.4 7here are the "radin# Markets9 3.4.1 "he Ma#nitude of "radin# 3.4.2 Stock Markets - Aist 7hen companies have their stocks available to be traded on o e%changes - Aisting fees Fees paid by corporations to be listed on an e%change when they o match e%change listing standards - Aisting standards ?e0uire listed companies to meet specic minimum standards for o capital value$ numbers of shareholders$ and nancial strength - :..( Method of reporting accounts o - #ontrol structures o ow shareholders elect the board of directors who appoint the managers and set company policy 3.4.2.1 "he >S Stock Markets - (rimary listing market o -%change where a corporate stock issue is primarily listed - Aisted stocks ,tocks listed at the *+,- and .merican stock e%change o - /ver!the!counter ,tocks listed on the *.,6.3 o o *ow >ust *asda0 stocks - ,pecialists o 6ealers who assist )oor brokers arrange trades for their clients on the )oor of the e%change - ?egional e%changes Boston stock e%change$ #hicago stock e%change$ #incinnati stock o e%change$ archipelago e%change$ and (hiladelphia stock e%change - &nlisted trading privileges o
?egional e%changes trading *asda0 stocks (rivileges granted by the ,-# o - 'hird market "ncludes dealers and brokers who arrange trades in e%change!listed o stocks away from an e%change 6isplay 0uotes on the *asda0 intermarket o - .lternative trading systems arious electronic trading systems in which &, stocks trade o ,ponsored by registered broker!dealers o - -lectronic communications networks Best known alternative trading systems o o -lectronic e%changes consist most of alternative trading strategies - Fourth market o 'rading in e%change!listed stocks within these systems - 7orld federation of e%changes #lassies markets by how they count their volumes o o #lassies *+,- as a ', and *asda0 as an ?- - 'rading system view o Markets count only transactions that pass through their trading systems or that occur on their trading )oors o *+,- ?egulated environment view o #ount all transactions that are sub>ect to their regulatory supervision *asda0 o 3.4.2.2 Internationa+ Stock Markets 3.4.3 $uit( Options Markets 3.4.3.1 >S Markets - ,ide!by!side trading - /ver!the!counter "Bs trading specialized option contracts with their clients o - ,ynthetic derivatives business "nclude structural products Kprimarily swaps Kthat "Bs create for clients o o "Bs trading specialized option contracts over!the!counter - ,tructured products &sually swaps when synthetic derivatives are included o - FA-L Fle%ible e%change o o &sed to capture institutional business in specialized options - /ptions - ?e0uest for 0uote o ,pecial re0uest procedure where institutional traders specify option type$ strike price$ maturity date$ and e%ercise style 3.4.3.2 Internationa+ $uit( erivatives Markets 3.4.4 5utures Markets - 6elivery months &sually at least for commodities o - Front contracts o #ontract that will e%pire ne%t - Front month contract o
,ee 4front contract5 - Back contracts #ontracts that don=t e%pire ne%t o - First harvest contract First contract on which traders can deliver the currently growing crop o 3.4.4.1 >S 5utures Markets - Boards of trade -%changes that trade standardized futures contracts in the &, o 3.4.4.2 Internationa+ 5utures Markets - Futures industry 3.4.& orporate and Municipa+ Bond Markets - /ver!the!counter ow most corporate and municipal bonds trade o 3.4.* "reasur( Markets ! "nterdealer brokers o
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3.4., S!aps and Spot urrenc( Markets 3.& Market )e#u+ation 3.&.1 )e#u+ators 3.&.1.1 ncertaint( 4.4 imit Orders 4.4.1 imit 8rice 8+acement 4.4.2 Standin# imit Orders are "radin# Options that OAer iuidit( 4.4.3 "he $%pected ompensation for OAerin# iuidit( 4.4.4 "he )isks of >sin# Standin# imit Orders 4.4.& imit Orders )epresent bsent "raders 4.& Stop Orders 4.&.1 Stop Orders and imit Orders 4.&.2 Stop Orders and iuidit( 4.* Market-If-"ouched Orders 4., "ick Sensitive Orders 4.,.1 "ick Sensitive Order 8roperties 4. Market-/ot-=e+d Orders 4.6 a+idit( and $%piration Instructions 4.1 @ua+it( Instructions 4.11 Other Order Instructions
4.12 Summar( 4.13 Some 8oints to )emember G1 @uestions for "hou#ht
