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 Exchange s Institutional Investors Investment Banks 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 Costs Portfolio Variance # of securities in the portfolio Market Portfolio under 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 I Classify 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.