Handbook

This undergraduate course is specifically aimed at either fourth year students or other students with a maths/programming background. It critically evaluates models of financial markets (market microstructure) and examines how asset prices are established in actual markets such as the stock exchange based on actual trades.  It differs from asset pricing theory in which prices are assumed to be set such that supply and demand are equated via some costless auction-type frictionless mechanism that remains an undisclosed ‘black box’. Actual markets require actual rules and these rules affect the way in which prices are established, the way in which information possessed by traders is incorporated into asset prices, why some markets and stocks are liquid and why some markets are more fragile and costly than others.  

While this course is based on an excellent text by three leading lights in the field, it is supplemented by a number of state-of-the-art studies that significantly advance our understanding of the role of different types of risk-volatility and illiquidity-in determining asset prices and the equity premium, for example, why it is that households can outperform professional investors?, how information contained in the stock price enables boards and CEOs to be monitored, and the role of counterparty transparency in improving market efficiency. Many of these papers are written by or with former students in the course.  

It first presents the basic modelling and tools used in the market microstructure field which analyses how prices are established in securities markets and whether or not markets are liquid. The course then analyses components of market design such as transparency and fragmentation (maker-taker fee structures and inverted markets, how investor heterogeneity leads to the (false?) rejection of asset pricing models, and how market design affects asset prices and corporate performance. 

This market microstructure course helps to address many of these fundamental issues, as well as equip students to read, understand and apply the rapidly developing market microstructure field in areas such as merchant banking. 

The goal of the course is to establish perspectives, approaches, tools and methods of independent thinking, analysis, and problem solving. Topics include exchange design rules, transparency and opacity, asymmetric information, private information, liquidity provision and pricing, volatility, transaction costs, strategic and noise trading, algorithmic trading, information and trading profits, dark pools, liquidity and returns. Three groups of traders are considered: domestic and foreign institutions and households. Households can be clients of either ‘full-service’ brokers or ‘discount’ brokers.  

This course complements courses in asset pricing that students may have done or be doing. Analysis of microstructure is also becoming increasingly relevant for research in other areas such as corporate finance.