Trading and Exchanges: A Course

in Market Microstructure

Prof. Eugene Kandel

NES, September 2006

Lecture 1

Introduction

The Role of Financial Markets

Administration I• Introductions.

• Syllabus.

• The coursework consists of:

– Lectures;

– Readings;

– Exercise.

• Book: Lawrence Harris, Trading and Exchanges,

Oxford University Press.

Administration II

• Grades

Class Participation 10%

Problem set (due Sept 26) 30%

Final Exam (on Sept 28) 50%

Total: 100%

• Exercises – not for grade. We will discuss some

of them in class, and I may use them for compiling

exam questions.

Objectives of the Course

• Learn about the markets using a coherent conceptual framework.

• Appreciate the complexity of market design, and the importance of details that cannot be seen in a “macro” view.

• This course will, hopefully, make you a better investor, but will not train you as a trader.

We will examine:

• Why do people trade, and how they do it;

• What do markets/exchanges add to society;

• Which market characteristics appeal to investors;

• Why are markets organized this way;

• The recent changes in market design;

• The role of public policy.

CAPM View of the Market

• Assumptions: – investors and firms interact directly,

– perfect competition (small investors and firms),

– full information,

– costless reallocation of portfolios.

• An elegant model, with clear predictions.

CAPM Model Development

CAPM View

Investors Firms

Securities

Cash today

Results

• Firms issue securities and investors hold them. Every investor holds the same market portfolio.

• The model is about holding securities and pricing them according to the fundamentals.

• Each investor can buy/sell any amount at the same price…

• …yet, there is practically no trading.

Problems with CAPM View

• As we look closer, we find:

– Information incompleteness and asymmetry;

– Need for price (information) discovery;

– Absence of trading counterparties;

• Markets and institutions arise to address these

problems. However, these are costly, and do not

eliminate the problems entirely!

Used Cars Market

Who addresses the following problems?

– Buyers/sellers may not know about each other.

– Buyers/sellers may not know the relevant price;

– Sellers may have informational advantage

– Sellers and buyers arrive at different times

– Newspapers, Blue Books, auctions, brokers, dealers.

Micro View

Investors Firms

Commercial Banks

Exchanges

Institutional Investors

InvestmentBanks

Brokers

Information Providers

Liquidity Providers

Securities

• Equities – various types of stocks;

• Corporate Bonds;

• Commercial paper;

• Other securities:– Government bonds;

– Indices – e.g. ETFs;

– Futures - commodities, currencies, indices;

– FX - spot;

– Derivatives.

Market types

• Primary vs. Secondary.

• Quote driven vs. Order driven.

• Continuous vs. Call.

• Electronic / Open Outcry /

Negotiated.

• Levels of transparency.

Institutional Investors

• Mutual funds, pension funds, hedge funds, and money managers.

• Economies of scale in diversification, research, and execution.

• Some are mandatory, others sell diversification, or security picking ability.

• Moral Hazard (agency) problems.• Institutional investors’ activism and corporate

governance.

Brokers

• Allow access to markets.

• Verify creditworthiness.

• Provide bundled services.

• Provide information, but face competition.

• Find liquidity and match trades - compete

with exchanges (ECNs and Nasdaq).

Commercial and Investment Banks

• Commercial Banks:– Loans and deposits

– Conversion: denomination, credit, and maturity;

– Delegated monitoring.

• Investment Banks:– Certification;

– Marketing;

– Information provision.

Information Providers

• Analysts:– Sell side - moral hazard problems;– Buy Side - less conspicuous.

• Rating Agencies.

• Newspapers and newsletters.

• Value Line.

• Internet.

The Effects of Transaction Costs

• CAPM with transaction cost:– Nobody holds market portfolio;– Idiosyncratic risk;– Portfolio imbalances;– Higher required return.

• Transaction cost is only one aspect:– Liquidity risk;– Price deviation risk.

CAPM with Transaction CostsPortfolio Variance

# of securities in the portfolio

Market Portfoliounder CAPM

Optimal number of securities with transaction cost

Nn

Summary

• Financial institutions arise to solve problems that

are not observable from the macro view.

• We focus on these problems and study some of

these institutions, in particular the exchanges.

• First discuss concepts, then follow with examples.

• Exercise: see below.

Exercise IClassify one of the following exchanges, according to criteria presented in class:

– American Stock Exchange;– Deutsche Bourse; – London Stock Exchange;– Milan Exchange;– Paris Bourse - Euronext;– Tokyo Stock Exchange; – Toronto Stock Exchange.