1.

Introduction to financial markets

Financial markets:

- Trading Instruments

- Traders

- Orders

- Organizational structures

Harris (2002), Hasbrouck (2007)

1
 1. Introduction to financial markets

Trading instruments
Securities, contracts, commodities, and currencies.

Real assets
Commodities, real estate, machines, intellectual properties
(patents, art).

Financial assets
Instruments that represent ownership of real assets and the cash
flows that they produce: stocks, bonds, currencies.

Derivative contracts: options, futures, forwards, swaps. 2

 1. Introduction to financial markets
1.1 Traders
1.1.1 Proprietary traders
1.1.1.1 Profit-motivated traders:
- informed traders
- technical traders
- dealers
also:
- rational investors
- value investors - arbitrageurs

1.1.1.2 Utilitarian traders

- hedgers
- liquidity traders
- noise traders
3
 1. Introduction to financial markets
1.1.2 Brokers (agencies)
- matching clients buy and sell orders
- connecting to markets
- settlement: delivery of traded assets
- clearing: reporting, credit management,
tax handling, etc.
- providing market data
- providing research
- offering credit

Buy-side vs Sell-side

Sell-side + brokerage => broker/dealer

4
 1. Introduction to financial markets

1.2 Orders
1.2.1Main definitions:
- instrument
- quantity (size/amount)
- market side (buy/sell)
- price: market orders vs limit orders
- bid/ask (offer) reservation prices
- best bid/ask prices => bid/ask spread
- inside/outside market = inside/outside the spread
- mid-price
- limit order book (LOB)
- marketable limit orders (who needs them?)
5
Example of LOB

6
 1. Introduction to financial markets

1.2.2 Conditional order types:

- good-till-cancelled
- market-on-open (-close)
- stop-orders
- fill-or-kill
- all-or-none

1.2.3 Short selling

short sell => buy to cover
up-tick rule

7
 1. Introduction to financial markets

1.2.4 Special orders:

- Pegged orders
primary - pegged to the best price on the same market side
market pegged to the best price on the opposite market side
mid-price pegged to the best bid/ask mid-price
- Cancel & Replace changes the order size but retains position in LOB
- Hidden orders hidden part has a lower priority but retains position in LOB

8
 1. Introduction to financial markets

1.4 Bid/ask spread

1 T
Quoted spread: SQ = ( At Bt )
T t 1

1 T
Effective spread: SE =
T t 1
2qt ( Pt M t )

Mt = 0.5(At + Bt), qt =1 (-1) for buy (sell) orders

Pt transaction price
1 T
Realized spread: SR = 2qt ( Pt M t 1 )
T t 1

9
 1. Introduction to financial markets

1.5 Liquidity
- breadth
- depth
- resiliency

Amihud (2002):
N
1
ILLIQ =
N
| r
k 1
k | / Vk

rk and Vk are return and volume at time k.

10
 1. Introduction to financial markets
1.6 Market structures: Big picture

Exchanges (bourses) highly regulated markets

Initial public offering (IPO) is listed on some exchange. After IPO,

the issuer sells this security to investors in a primary market.
Subsequent trading of securities among investors other than the
issuer is conducted in the secondary market (or aftermarket).
Trading of exchange-listed securities in an OTC markets is referred
to the third market.

Alternative to exchanges: over-the-counter (OTC) markets

11
 1. Introduction to financial markets

1.6 Market structures: Big picture (continued)

US regulators:
Securities and Exchanges Commission (SEC) stocks & bonds
Commodity Futures Trading Commission (CFTC) commodities

Self-regulatorary organizations for brokers and dealers:

Financial Industry Regulatory Authority (FINRA)
National Futures Association (NFA)
Also
Financial Accounting Standard Board (FASB)

12
 1. Introduction to financial markets
1.6 Market structures: Big picture (continued)

Market structure: execution system + trading session type

Execution systems: order-driven markets & quote-driven markets

Order-driven market sessions: continuous markets & call markets

Most order-driven markets are auctions in which price discovery (market

clearing) results in that trading occurs at a highest price that a buyer is
willing to pay and at a lowest price that a seller is willing to sell at.

13
 1. Introduction to financial markets

1.6 Market structures: Big picture (continued)

Crossing networks (dark pools): derivative pricing rule

Pros:
- confidentiality
- no price impact
Contras:
- low fill ratio
- deteriorating price discovery (trade at rule)

14
 1. Introduction to financial markets
1.7 Continuous order-driven markets
Limit orders that are not matched upon arrival are entered into the LOB according to
the price-time priorities. Price priority has the primary precedence.
Size precedence rarely used.

Matching: First In, First Out (FIFO) principle.

Example:
Order Price Size A market buy order of size <= 200 will be filled
Ask2 10.35 200 at the price of 10.30. If the size of the market
buy order equals 200, it completely matches A1
Ask1 10.30 200 and the bid/ask spread jumps from 0.05 to 0.1.
Bid1 10.25 100
Bid2 10.23 200

15
 1. Introduction to financial markets

1.8 Call auctions (rules)

Call auctions are conducted several times a day (fixings) or at the
openings and closings of continuous sessions. Orders submitted for
a given call are batched and executed simultaneously at the same
price. Prior to auction, all submitted orders are placed according to
the price-time precedence rules. Aggregated demand and supply
are calculated implying that a trader willing to buy/sell at price P will
also buy/sell at a price lower/higher than P.
The auction price is defined in such a way that yields a maximum
aggregated size of matched orders. In case the rule of maximum
aggregated size of matched orders does not yield a unique price,
the auction price is chosen to satisfy the rule of minimum order
imbalance (i.e. the minimum number of unmatched orders). If even
the latter rule does not define a single price, the auction price is
chosen to be the closest to the previous auction price.

16
 1. Introduction to financial markets

1.8 Call auctions (example)

Pre-auction order book

17
 1. Introduction to financial markets

1.8 Call auctions (example continued)

Price discovery

18
 1. Introduction to financial markets

1.9 Oral (open-outcry) auctions

Traders (brokers and dealers) gather in the same place (floor
market). Traders are required to communicate (using shouting and
hand signals) their trading intentions and results of trading to all
market participants.
In oral auctions, order precedence rules and price discovery are
similar to those in continuous order-driven markets. However, there
may be some additional secondary precedence rules. In particular,
public traders have priority in respect to floor traders.

19
 1. Introduction to financial markets

1.10 Quote-driven markets and hybrid markets

In the quote-driven markets, only dealers submit maker orders. All

other traders can submit only market orders. Price discovery in
these markets means that market makers must choose such bid
and ask prices that will cover their expenses and balance buy and
sell order flows.
Some markets combine quote-driven and order-driven systems in
their structure. NYSE and NASDAQ are examples of such hybrid
markets.

20