Empirical Market Microstructure: The Institutions, Economics and Econometrics of Securities Trading

Empirical Market Microstructure: The Institutions, Economics and Econometrics of Securities Trading

Empirical Market Microstructure: The Institutions, Economics and Econometrics of Securities Trading

Empirical Market Microstructure: The Institutions, Economics and Econometrics of Securities Trading


The interactions that occur in securities markets are among the fastest, most information-intensive, and most highly strategic of all economic phenomena. Empirical Market Microstructure is about the institutions that have evolved to handle our trading needs, the economic forces that guide our strategies, and statistical methods of using and interpreting the vast amount of information that these markets produce. The empirical methods discussed in the book draw on the power of multivariate linear time series analysis. The book discusses the application of univariate ARMA analysis to trade prices, vector autoregressions to price and order data, and vector error correction models to situations where the same security is traded in many markets. In these models, the tools of random-walk decomposition and co-integration emerge as important to specification and interpretation. The statistical specifications dont simply arise, however, as progressively more refined descriptive models; they have strong economic underpinnings arising from asymmetric information, inventory control, and the strategies of their participants. These topics are discusssed, interleaving with and emphasizing the connection to the statistical models. From a practical viewpoint, many of these models will be estimated to calibrate real-world trading strategies. Some market participants will be trying to discern strategies that generate profits from short-term trading. A much greater number, though, will be trying to accomplish trades that help diversify, hedge or reallocate a portfolio. Trading is not, for these agents, their primary economic purpose. They are simply trying to satisfy their trading needs at a minimal cost. The final part of the book discusses how these costs are measured, and strategies to minimize them--both by splitting orders over time, and by the judicious use of limit orders. The book includes numerous exercises; solutions and other supporting materials are available on the author's web site.


This book is a study of the trading mechanisms in financial markets: the institutions, the economic principles underlying the institutions, and statistical models for analyzing the data they generate. the book is aimed at graduate and advanced undergraduate students in financial economics and practitioners who design or use order management systems. Most of the book presupposes only a basic familiarity with economics and statistics.

I began writing this book because I perceived a need for treatment of empirical market microstructure that was unified, authoritative, and comprehensive. the need still exists, and perhaps someday when the field has reached a point of perfection and stasis such a book will be written. in the meantime I simply endeavor to identify and illuminate some themes that appear, for the moment at least, to be defining the field’s arc of progress.

Three of these themes are especially prominent. the first is the institution that has come to dominate many of our most important markets—the (electronic) limit order book. Much of the material here can be perceived as an attempt to understand this mechanism. the second theme is asymmetric information, an economic term that refers to the varying quality of the information that traders bring to the market. It often establishes a motive for trade by some individuals, but also frequently leads to costs borne by a larger number. the third theme is linear time-series analysis, a set of statistical tools that have proven to be robust and useful not simply in describing security market data but also in characterizing the underlying economic structure.

Although the institutional, economic, and statistical content of the book can be read separately and selectively, there is a natural ordering to these perspectives. the features of real-world trading mechanisms motivate almost everything else, so an early chapter provides an accessible summary that is largely self-contained. Once this framework has been established, the economic arguments that follow will seem more focused. the statistical time-series models are then brought in to support, refute, or calibrate the economic analyses.

The discussion of time-series analysis here is not as deep as a textbook focused solely on the subject, but it is more substantial than an applied field book would normally attempt. I weave through the book coherent and self-contained explanations of the time-series basics.

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