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Market Microstructure: A Review of Literature

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RJFSR VOL. 2 NO. 2, 2017Aigbovo O. & Isibor B.O.

Market Microstructure: A Review of Literature

Aigbovo, O.1 & Isibor, B. O.2

1,2
Department of Banking and Finance, University Of Benin
Email: omoruyi.aigbovo@uniben.edu
2
Email: findosas@yahoo.com

ABSTRACT

This paper reviews the literature about market microstructure, broadly defined to include
conceptual and the diverse strands of models that make the microstructure theory thick. The
study will help market participants to understand how information risk due to asymmetric
information and difference in liquidity over time and between companies impact on long term
equilibrium prices in the stock market.
Key words: Market Microstructure, Information Asymmetry, Market architecture, Sunshine
Trading, Market Transparency.

1.0 Introduction

Market microstructure has seen a lot of growth in the last two or three decades. Interest in market
microstructure is most obviously driven by the rapid structural, technological and regulatory
changes affecting the securities industry worldwide. When we look at the security price
dynamics with respect to market microstructure, our focus has shifted from monthly or daily to
minute or tick level with more features such as bid price, ask price, bid size, ask size, trade price
and trade volume among others. The additional features of price and trading dynamics reflect the
complexity of microstructure (Madhavan, 2000).

Hasbrouck (2007) lists the following three features as setting the study of market microstructure
apart from a more classical view of financial economics. First, microstructure seeks to
understand the sources of value and reasons for trade, in a setting with different types of traders
and different private and public information sets. Second, the actual mechanisms of trade are a
continually changing object of study. These include continuous markets, auctions, limit order
books, dealer markets, or combinations of these operating as a hybrid market. And third,
microstructure has to allow for the possibility of the multiple prices. At any given time an
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investor may be faced with multitude of different prices, depending on whether he or she is
buying or selling, the quantity he or she wishes to trade, and the required speed for the trade. The
price may also depends on the relationship that the trader has with potential counter parties

During the last few decades, market microstructure has become an important discipline within
the field of finance. The processes and rules of exchanging securities are considered an important
issue since they affect the way in which trades are determined, prices are formed and scope of
asymmetric information. Determining the components of the market microstructure black-box in
terms of trading mechanisms and regulations governing various aspects of trading process allows
researchers to identify and compare the themes in market microstructure and issues facing the
process of trading securities. It also provides necessary input to the regulatory bodies to enhance
the design of better markets. Consequently, investors and portfolio managers will make better
trading decisions by understanding how markets work (O'Hara, 1987).

This study focused on stock market microstructure, that is, secondary market trading strategies
and trading cost; how trading on stock exchanges is organized and regulated; and how this
affects their functioning in terms of trading costs, information efficiency, volatility and other
measures of performance.The objective of this paper is to provide a comprehensive review of the
market microstructure literature, broadly defined to include conceptual and the diverse strands of
models that make the microstructure theory thick.The rest of the paper is structure as follows. In
section two we review the conceptual literature while the theoretical literature on market
microstructure is presented in section three. Section four provides the summary and conclusion.

2.0 Conceptual Clarification

Concept of Market Microstructure: O'Hara (1995) defines market microstructure as "the study
of the process and outcomes of exchanging assets under explicit trading rules”. Spulber (1996)
has provided a broader definition of market microstructure which is the study of the
intermediation and the institutions of exchange. Madhavan (2000) define market microstructure
as the process by which investors' latent demands are ultimately translated into prices and
volumes. Asmar and Ahmad (2011) define market microstructure as the study of trading
mechanisms and regulations used to accomplish a trade. Trading mechanisms refer to the
methods of trading securities. The mechanisms are determined by several dimensions including

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market type, price discovery, order forms and degree of transparency. Market Regulations on the
other hand refer to the rules of trading securities defined by securities market to control various
aspects of trading process, such as the rules of order priority, tick size and spread, listing, trading
unit, price thresholds, trading status, short selling and off-market trading. National Bureau of
Economic Research (NBER) defines market microstructure as a field of study that is devoted to
theoretical, empirical, and experimental research on the economics of security markets. It
includes the role of information in the price discovery process, the definition, measurement and
control of liquidity, and transaction costs and their implication for efficiency, welfare, and
regulation of alternate trading mechanisms and market structures

One important implication drawn from these definitions is that the market microstructure is
shaped by trading mechanisms and trading regulations. It is imperative to note that Market
Microstructure bothers on the way a market or exchange functions under a given set of rules.
Issues like market structure and design, price formation and price discovery, transaction and
timing cost, information and disclosure, market maker and investor behavior, etc., are dealt with
in market microstructure. This factor focuses on the relationship between price determination
and trading rules.

Market structure and design issues: Trading mechanisms refer to the methods of trading
securities and these mechanisms are determined by several dimensions which include market
type, price discovery, order forms and degree of transparency. All these mechanisms put together
forms the market architecture or design. A second half of the market microstructure that is
required in accomplishing a trade and is the rules of trading securities defined by securities
market to control various aspects of trading process(Madhavan, 2000)..

Market architecture: According to Madhavan (2000), Market architecture refers to the set of
rules governing the trading process, determined by choices regarding the market type, price
discovery, order forms, protocol and transparency. The issues to be addressed in the market
design or market architecture include whether the market should be a call or a continuous
market.

In the succeeding section, the researcher describes the salient features of the different trading
systems that operate in the world today. This would facilitate a critical discussion on market

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structure and design issues that are critical to an understanding of the price formation process in
financial markets. The researcher begins by explaining the market types, prices, orders, and
trading priority rules that are commonly used in market microstructure parlance.

Market type: Securities market type has three dimensions which are degree of continuity,
reliance on market makers and degree of automation (Madhavan, 2000).With regard to the
degree of continuity, there are two types of market: the first one is the "call market” where
selling and buying orders are grouped together during an interval period of time. The second one
is the continuous auction market, where selling and buying orders are executed whenever
submitted. The executing price represents the highest price that a buyer is willing to pay and the
lowest price that a seller is willing to sell (Chang, Hsu, Huang & Rhee, 1999).

With respect to the reliance on market makers, (which refers to whether trade between public
investors is with or without dealer/specialist intermediation), securities exchange is considered as
quote-driven market where prices are determined from quotations made by market makers or
specialists. While securities exchange considered as order-drivenmarket or auction marketwhere
prices are determined by the publication of orders to buy or sell shares via public investors
without market makers' intermediation (Madhavan, 2000). One of the important questions in
microstructure research is how market structure affects trading costs and whether one structure is
more efficient than another. Concerning the degree of automation, trading mechanisms can
operate either on the floor or by means of screen-based electronic systems. Regarding trading on
the floor, trading mechanism relies on an open outcry method where exchange uses face to face
verbal and hands signal. In the second type, trading mechanism employs an electronic or
automated trading system where participants key in the orders. It has been found that automated
markets present more transparency in market transaction and trading rules meant to improve
market efficiency(Madhavan, 2000).

Prices: An ask quotation is an offer to sell at a specific price, the ask price. It is also sometimes
called the ask price. A bid quotation is an offer to buy at a specific price, the bid price. The price
at which a transaction occurs is denoted as the transaction price. Transaction prices usually occur
at previously announced bid or ask quotations but could also occur at a price that is in between
the bid and the ask price (Madhaven & Smidt, 1993).

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Orders: A public trader gives an order to a broker who acting as the trader's agent directs the
order to a market where the trade may be arranged. The trader must specify the exact number of
shares to be bought or sold. In addition, the trading instruction should also include the price at
which the trade is to be made. Based on how the trader specifies the price of trade, orders may be
classified into either market orders or limit orders. A market order to buy or sell is to be executed
at the best price established on the market at a given point in time. For a market order seller
(buyer), the best price is the highest (lowest) bid (ask) posted by a potential buyer (seller). A
limit buy (sell) order specifies the maximum (minimum) price at which the trader will buy (sell)
(Madhavan, 2000).

Sunshine Trading: Sunshine trading is an aspect in market microstructure that concerns the
disclosure of information about pending orders. In sunshine trading, some liquidity traders can
preannounce the size of their order while others cannot. Those investors who are able to
preannounce their trades enjoy trading costs while those who are not able to preannounce their
trades suffer from high trading process(Madhavan, 2000).

Taxonomy of Market Systems: Trading systems can be classified on the basis of participants.
Using this classification, we have(a) Dealer Markets and (b) Agency Markets. A broker is a
trader's agent. A broker does not herself participate in the market but merely matches the order
with counterparty on the other side of the transaction. A dealer on the contrary in a trade
participates as a principal.

Dealer Markets: As a principal, a dealer satisfies a public order by buying for her own
inventory or by selling from her inventory. In a dealer market, public traders do not trade directly
with each other but with a dealer who serves as intermediary. The over-the-counter (OTC)
market in the United States is an example of a dealer market (O'Hara, 2003).

Agency Markets: In an agency market, public orders are directed to a broker's broker who
matches them with other public orders. Market professionals do not participate in trading in an
agency market. The Tokyo Stock Exchange (TSE) is an example of a pure agency market. The
TSE is established by the limit order book(O'Hara, 2003).

Price Formation and Price Discovery: This factor focuses on the process by which the price
for an asset is determined. The price would include the transaction cost of the asset. Transaction

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costs include order processing costs, adverse selection costs, inventory holding costs, and
monopoly power. For example, in some markets prices are formed through an auction process,
(for example, an electronic Bay).In other markets prices are negotiated (e.g., new cars) or simply
posted (e.g. local supermarket) and buyers can choose to buy or not.Markets have two principal
functions according to O'Hara (2003). They are provision of liquidity and the facilitation of price
discovery. Clearly asset prices evolve in markets. This evolution is influenced by the nature of
players in the market and the trading system in vogue (O'Hara & Oldfield, 1986).

Traditional market microstructure literature has categorized traders based on their information
system - informed traders and uninformed traders. Informed traders have an informational edge
regarding the stocks that other traders do not possess. They exploit this informational advantage
while trading with others. The uninformed investors trade for non-informational reasons. In some
cases, they are termed as "noise traders," since their trade is based on their beliefs and
sentiments that are not grounded on fundamental information. Information is revealed to the
market through the trading activities of informed traders (O‟ Hara, 2003).

Bid-Ask Spread: Bid-ask spread exist due to the existence of an order imbalance in real-time.
Buy and sell orders do not arrive simultaneously to clear at the existing equilibrium price. An
explicit or implicit market maker provides a two-way quote - a buying price and a selling price
with associated quantities for immediate execution. The bid-ask spread is then the compensation
for providing immediacy. Market impact costs are due to large orders moving the transaction
prices albeit temporarily. Real-world securities markets are characterized by several
imperfections. A liquid market is characterized by breadth, depth, and resiliency. Breadth refers
to the existence of orders in substantial volume. Depth is the existence of orders on both sides of
the market near the current equilibrium price. Resiliency is the responsiveness of new orders to
price changes caused by temporary order imbalances. A market is not resilient when the order
flow does not quickly adjust to errors in price discovery (Madhavan, 2000).

Information and Disclosure: There are many informational issues surrounding market
microstructure. These include information dissemination and disclosure as well as information
efficiency. Madhavan (2000) defines market transparency as the ability of market participants to
observe information about the process. Information in this context refers to knowledge about
prices, quotes, volumes, sources of order flow, and the identities of market participants.

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Market Transparency: Market usually is transparent when high quantity and quality of
information regarding current and past prices, quotes, depths, volumes and the identities of
market participants are rapidly available to the public. In this sense 'market transparency refers to
the ability of market participants to observe information about the trading process'. A transparent
market is one in which information in the form of order flows, including prices, quotes, volume,
timing, form of order, sources of order flow and perhaps identity of market participant can be
observed. In transparent markets abundant information is available to investors and traders about
orders and quotes (ex-ante transparency) and about transactions (ex-post transparency). As this
tends to equalize information across market participants, transparency reduces the magnitude of
adverse selection problems (O'Hara, 1995).

Market regulation: Market microstructure includes the trading mechanisms and regulations as
the main components of the black box. Trading mechanisms determined by market type, price
discovery, order forms and degree of transparency, whereas market regulations includes the rules
of order priority, tick size and spread, listing, trading unit, price thresholds, trading status, short
selling and off-market trading. Market Regulations refer to the rules of trading securities defined
by securities market to control various aspects of trading process, such as the rules of order
priority, tick size and spread, listing, trading unit, price thresholds, trading status, short selling
and off-market trading. Since the market microstructure is shaped by the trading mechanisms and
trading regulations carried out by the securities exchange, it means therefore that the rules and
trading regulations "that defines the market structure are a primary function of the Exchanges as
Self-Regulatory organizations (SROs), Market regulation cuts across the following areas: Rules
of Order Priority (Madhavan, 2000). Demarchi and Foucault (2000) contend that the price
priority and then time priority is most favorable as it leads to price competition among traders.
For instance, price and time priority rules take place in the continuous auction markets where
market rules often require the highest of bid or lowest of ask price order received to be executed
first. In case of two bids or asks are received at the same price, the first entered bid or ask order
is given priority and is executed first. Unlike the continuous auction markets, the dealer markets
do not operate under price and time priority rules. In this type of markets, it is a sine qua non for
brokerages to seek the preferable prices for trader orders. Other rules include: Rules of Tick Size
and Spread, Rules of Listing, Rules of a Trading Unit and Rules of Price Thresholds (Limits).

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Taking into account the components of market microstructure is important for conducting
research in market microstructure and it is related to other area of finance. More importantly as
long as the research in market microstructure plays a role in providing a necessary input to the
issues of how to design and conduct the trading, therefore, taking into consideration the
components of market microstructure is important for addressing such issues in future and
enhancing the design of markets as well as improving the trading strategies of individual
investor. Setting the rules of the market is a primary challenge for every policy-maker: how far
should regulatory intervention go, so as to safeguard the interests of consumers while preserving
the dynamism of market competitors? The image of a stock exchange floor exemplifies the
vitality of markets, representing the constant interaction of buyers and sellers to form prices and
close trades (Demarchi and Foucault, 2000).

Market Microstructure Interface with Other Areas of Finance: A popular measure of

liquidity is the bid-ask spread which is the difference between the bid and the ask price quoted
by a dealer who makes a market in a stock. The bid-ask spread may be viewed as the price
required by the dealer for providing immediate execution of orders. Amihud and Mendelson
(1986) examine the relationship between bid-ask spread and stock returns. If investors assess the
value of a stock based on their returns net of trading costs, then they should demand a higher rate
of return for high spread stocks so as to compensate them for higher trading costs. Thus,
investment decisions should incorporate liquidity considerations in addition to risk. While an
investor can reduce the risk by holding a diversified portfolio, the cost of illiquidity cannot be
diversified away. Besides required rate of return, liquidity also affects the holding period of a
stock. The cost due to the bid-ask spread has to be borne by the investor only once over the
holding period. A premium is paid when the stock is purchased and a price concession is made at
sale. A longer holding period effectively reduces the amortized transaction cost per unit of time.
The larger the holding period of an investor, the lower the extra return required compensating for
the bid-ask spread. Thus, stocks with high bid-ask spread will be held by investors with longer
holding periods. Conversely, short-term investors should hold low-spread securities. Amihud and
Mendelson's framework points out to the benefits of liquidity increasing investments. As a direct
consequence of liquidity improvements via lower spreads, the value of a stock should increase.
This effectively decreases the cost of capital of the firm. One such move could be to switch the
listing of the stock to a more liquid trading environment.

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Madhavan (2000) assert that the interface of microstructure with other areas of finance is a
growing subject. A complete understanding of the time-varying nature of liquidity and its
relation to expected returns appears warranted given the growing evidence that liquidity is a
factor in explaining the cross-sectional variation in stock returns. Differences in liquidity over
time may explain variation in the risk premium and hence may influence stock price levels.
Much work remains in corporate finance. For example, the response of stock prices to new
information is very rapid, a matter of minutes rather than hours. Yet, most event studies use daily
returns as their unit of observation. Considerable evidence on the nature of corporate events
might be gleaned from high-frequency data analysis. Using microstructure techniques to
decompose the bid-ask spread (or price impacts) into transitory and information based
components, a researcher might be able to make a more precise determination of the market
perceptions regarding insider trading and asymmetric over time. Such a measure might be very
useful in testing hypotheses about the reaction of stock prices to earnings and dividend
announcements.

3.0 A Review of Market Microstructure Theory

Traditional microstructure theory provides two major directions to explain price setting behavior:
inventory models and asymmetric information based models. The branch of inventory models
investigates the uncertainty in order flow and the inventory risk and optimization problem of
liquidity suppliers under possible risk aversion while the asymmetric information based models,
model market dynamics and adjustment processes of prices using insights from the theory of
asymmetric information and adverse selection. The two main approaches in asymmetric
information models are sequential trade models and strategic trade models. In addition to the
asymmetric information based models there is also the synthetic model that incorporates both the
adverse selection and inventory/order handling cost.

Inventory-based models

Inventory models consider the inventory problem of a dealer who is facing buyers and sellers
arriving asynchronously. The models postulate the primary role of market-makers as liquidity
providers and show how the bid-ask spread compensates them for price risk on inventory. In the
inventory model, the trading process is a matching problem in which the market maker, facing an

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unbalance risk, uses the price to balance supply and demand across time, with the key factors
being the inventory position and the uncertainty surrounding the order flow. Market makers
achieve the inventory control by shifting the quotes (bid and ask) to elicit the imbalance of buy
and sell orders. The bid-ask spread increases with the market maker's risk aversion, the size of
the transaction, the risk of the asset and the time horizon, or it may reflect the dealer's market
power. In modelling the spread arising from inventory risk, the determination of a dealer's bid
price is considered. The bid price must be set at a discount below the consensus value of the
stock to compensate for inventory risk. Seminal papers in this area include Garman (1976), Stoll
(1978), Amihud and Mendelson (1980), and Ho and Stoll (1981, 1983). Other papers that have
modelled the time-series behaviour of prices and quotes include Roll (1984), Hasbrouck (1991),
Huang and Stoll (1994, 1997), and Madhavan, Richardson and Roomans (1997) among others.

Garman (1976) Model: The string of the literature on inventory based models originates from
Garman (1976) who models the arrival processes of buyers and sellers as Poisson processes. The
arrival intensities depend on the price they pay or receive, respectively. Hence, as long as the
intensities are equal, the dealer is on average buying and selling at the same rate. The dealer
makes profits by setting a spread. Then, the larger is the bid-ask spread, the higher are the profits
per trade but the lower is the trade arrival rate. Garman (1976) characterizes the inventory
problem of the market maker who has to ensure that her holdings of the security and cash do not
drop below a given level. If ask and bid quotes are set such that the resulting arrival intensities
of buyers and sellers are equal, holding of stock follow a zero-drift random walk while cash
holding follow a positive-drift random walk (as long as the spread is strictly positive). This
causes the market maker to go bankrupt with probability one as a zero-drift random walk hits
any finite level with probability one. Hence, as long as the market maker keeps ask and bid
quotes constant, she must expect to be ruined within short time.

The model has stylized assumptions that do not allow changing prices and borrowing cash; buy
and sell orders follow independent stochastic processes; and inventory follows a random work
with zero drift. Thus, under these assumptions, failure is certain over a finite time period (T).
This is the classic gambler‟s ruin problem. This means that market makers must actively adjust
prices in relation to inventory, rather than simply adjusting spreads as in the Demsetz model. In
this model, the spread arose, in part, because of the need to reduce failure probabilities. A

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particular limitation of the Garman model is the fact that whilst inventory determines the
market-maker‟s viability, it is not explicitly incorporated into the market-maker‟s decision
problem because of the assumption that the market-maker can only set prices at the beginning of
the trading period. This restriction severely limits the applicability of the model in a situation in
which prices continually change.

Amihud and Mendelson (1980) Model: Amihud and Mendelson (1980) present a framework
similar to that of Garman (1976) where the market maker‟s inventory is constrained to lie
between upper and lower bounds. They show that the market maker updates her quotes
whenever the inventory approaches these boundaries to drive up or down, respectively, the
arrival rates of buyers and sellers. The arrivals of buy and sell orders from liquidity traders
(uninformed) are characterized by two independent Poisson processes, with arrival rates
( )and ( ). and are stationary price-dependent rate functions representing the market
demand and supply, with () () . They address the limitation in Garman model by
explicitly incorporating inventory into the market-maker‟s pricing problem. In this model, the
dealer balances his inventory over time by changing his prices in each period of time. In other
words, the dealer lowers (or raises) bid and ask prices in response to a growing (or shrinking)
inventory that allows the dealer to achieve a preferred or target inventory position. Thus, this
model predicts that the level of bid and ask prices is a monotonically decreasing function of the
dealer‟s inventory. Finally, the optimal bid and ask prices exhibit a positive spread, and
inventory is bounded above and below by exogenous parameters, which removes the capital
constraints of the Garman model. This implies that the bid-ask spread arises from the market-
maker's efforts to maximize profits rather than simply reduce probabilities of failure.

Under the setting of their model, it can be shown that there exists a `preferred' inventory position
for the market maker and that when the market maker is in a position different from the
`preferred' position, he will quote prices which will tend to bring him back to that position. Also,
they show that for linear demand and supply functions, the transaction prices are serially
correlated and that this is still consistent with the market efficiency hypothesis.

Ho and Stoll (1981, 1983) Model: The Ho and Stoll (1981) model extends the intuition of the
Stoll (1978a,b) model, focusing on how a risk-averse dealer‟s inventory, order processing costs,

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and adverse selection risk affect a dealer‟s pricing. This model is significantly different from the
model of Garman (1976) and Amihud and Mendelson (1980). For instance, the dealer is risk-
averse and cannot hedge his inventory exposure. The dealer also maximizes the expected utility
of final wealth. Thus, the model demonstrates that variables such as the dealer‟s cash, inventory
and base wealth positions affect the dealer‟s optimal pricing strategy, which is determined by
setting bid and ask prices. The important findings of the optimal pricing strategy in the model
are that inventory causes the dealer to increase and decrease both bid and ask prices by the same
amount; thus inventory affects the level of bid and ask prices but does not affect the magnitude
of spread. Also, the spread increases to compensate for inventory and portfolio risks because of
the assumption of risk aversion. Finally, the spread is independent of the inventory level. In
other words, the spread is not affected by the dealer‟s inventory position, but the spread reflects
the dealer‟s risk aversion.Numerical solutions can be derived from dynamic programming and
an interesting result is that in an inactive stock, it is possible for the market maker to refuse to
make the market when she is required to trade a minimum amount, because the expected profit
from trading may not be enough to offset the risk.

Ho and Stoll (1983) demonstrate that the intuition of inventory affecting a dealer's quote levels
but not the magnitude of his spread is robust to multi-period and multi-dealer configurations. In
a multi-dealer setting, Ho and Stoll (1983) further predict that relative inventory positions
among dealers determine the amount of interdealer trading.

Roll (1984) Model: Roll (1984) suggests a model of high frequency trade prices which
incorporate market dynamics. This model is fundamental to many market microstructure models
such that it illustrates the distinction between price movement due to fundamental security value
and those attribute to market organization and trading mechanism. The former arises from the
earning capability and future cash flows of the underlying security, whereas the later are
transient due to market behavior. The model provides meaningful economic interpretation, and
in some cases, explains the market movement well. Roll (1984), attempt to explain how
inventory and order handling cost affect price. Roll (1984) assumes in an information efficient
market, the fundamental value of a security fluctuates randomly. However, trading costs can
induce negative serial dependence in successive observed market price changes.

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( ) ………………………………………………………………………….. (1)

Where; is the effective spread.

Stoll’s (1989) Model: Stoll (1989) examines the quoted and realized spread with the purpose of
modelling the behaviour of the spread and infer components of the spread. Stoll introduces
several parameters: the probability of a reversal ( ) and the value of a price continuation as a
fraction of the spread( ). He decomposes the spread into three components: order processing,
inventory holding, and adverse selection by examining the covariance of the trade returns and the
covariance of returns defined over the quoted bid ask prices. Under the assumption of market
efficiency, the serial covariance of price changes due to the spread may be inferred from
observed price changes, while the serial covariance depends upon the two-period (three-date)
sequence of prices.

Stoll calculates the three spread components from slope coefficients of regressions of the serial
covariance of the percentage price change of the bid-ask spread:

……………………………………………..………………………… (1)

……………………………………………...………………………… (2)

where is the squared value of the average quoted proportional spread (i.e., the difference
between the ask and bid quotes divided by the average of these quotes); is the serial
covariance of transaction price changes; is the serial covariance of changes in bid (or ask)
quotes; and are constant; and are the coefficient of spread, and u and v are random
error terms. The inventory holding cost model predicts that both covariance‟s are negative
because the probability of a price reversal is higher than 0.5 and .

Given and , Stoll solves for intermediate values, , the size of a price continuation as a
fraction of the spread, , the probability of a price reversal, and ( ), the probability of a
price continuation, from two auxiliary equations:

( ) ( ) ……………………………………………………………… (3)

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and

( ) ……………………………………………………………………………… (4)

The components of bid-ask spreads are then determined as follows:

Adverse Selection Cost [ ( ]………………………………..…………………….. (5)

Inventory Holding Cost ( ) …………………………………………………………(6)

Order Processing Cost ( ) ……………………………………….…………………… (7)

Hasbrouck (1988) Model: To estimate the effective trading cost and returns formed from daily
data, Hasbrouck advocates a Bayesian approach based on the Roll (1984) model. This method
accommodates a long time span by daily data, and the cost estimate is validated against
microstructure data.

Madhavan - Smidt and Hasbrouck - Sofianos (1993) Model: Madhavan and Smidt (1993),
and Hasbrouck and Sofianos (1993) find empirical support for dealers actually having such a
desired inventory level, but also for them appearing to be willing to move away from this
desired position for long periods. The main outcome of these inventory models is that dealers set
bid and ask prices in such a way as to cover their order-processing and inventory-keeping costs.
In cross section, assets with greater friction have larger spreads. Friction also affects the short-
term time-series behaviour of asset prices.

Huang and Stoll (1997) model: Huang and Stoll (1997) propose two-way and three-way spread
decomposition models. The two-way decomposition model does not separate adverse selection
and inventory holding components. The three-way decomposition model allows for the
identification of three components; adverse selection, order processing, and inventory holding
costs. The three-way decomposition of the spread is based on negative serial correlation in trade
flows and this can be used to identify the inventory holding cost component. Therefore, Huang
and Stoll (1997) model serial correlation in trade flows given by the conditional expectation of
the trade indicator at time t-1, given ( | ), can be expressed as:

( | ) ( ) …………………………………………………..……………. (1)

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Where is the probability that the trade at is opposite in sign to the trade at , ( )
is buy-sell trade indicator at time ( ) is different from one-half, and the market
knows equation above, the change in fundamental value will be given by

( ) …………………………………………………….. (2)

where is the total change in unobservable fundamental value of the stock in the absence of
transaction costs between time and , and is determined just prior to the posting of the bid-

ask quotes at time and , is the posted spread just prior to the transaction,

reflects the private information revealed by the last trade, as in Copeland and Galai (1983) and
Glosten and Milgrom (1985). The public information component is captured by . Huang and
Stoll estimate the components of the spread directly from the following equation:

( ) ( ) ………………………..…………….. (3)

where is the buy-sell indicator for the transaction price, . is the midpoint of the quote that
prevails just before the transaction at time in above equation. The estimation of and are
percentages of the half-spread attributable to adverse selection and inventory holding costs,
respectively. Since and are stated as proportions, the order processing component is equal to
( )

The Bollen, Smith, and Whaley (2004) model (BSW): The uniqueness of the Bollen, Smith,
and Whaley (2004) model rests in the use of the option approach to identifying the determinants
of the bid-ask spread. The market maker‟s spread includes a premium to cover expected
inventory-holding costs, independent of whether the trade is initiated by an informed or an
uninformed trader. In the BSW (2004) model, the authors assume that the length of time a stock
is held in inventory is known and short. BSW also assume that the risk-free rate and the expected
change in the true price of the stock are equal to zero for this short holding period. In the absence
of a viable hedging instrument, the market maker faces inventory – holding price risk for which
he will demand compensation. BSW show that the value that the market maker is willing to
charge to cover inventory holding costs is equal to the value of an at-the-money option with

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maturity given by the time that the stock is held. So, the inventory holding premium (IHP) is
defined as:

⌊ ( )√ ) ⌋ ……………………………………………….……………..…… (1)

where, is the stock price, is the standard deviation of the security return, t is the maturity and
( ) is the cumulative unit normal density function. Given that t is unknown, expected
inventory holding premium, E (IHP) is shown as follows:

( ) ⌊ { (√ )} ⌋ ………………………………………………………….… (2)

In the implementation of the model, (√ )is computed as the average of the square root of the
time between trades.

When asymmetric information costs are considered, a distinction is made between an informed
and an uninformed trader. BSW demonstrate that when the trade is uninformed, the
compensation demanded by the dealer equals the value of a slightly out-of-the money (OTM)
call option with an exercise price equal to the ask price. If the investor is informed, he knows that
true price of the stock will be above the ask price and the value of the compensation of the
market maker will be equal to the value of a slightly in-the-money call option. Hence, whether
the trader is informed (I) or uninformed (U), the market maker requires the following
compensation for bearing the risk of trading with the informed traders:

( ) ( )
[ √ ] [ √ ]………………………………………... (3)
√ √

where is the true stock price at the time that the market maker opens his position, is the
exercise price of the option, is the standard deviation of security return, t is the time until the
offsetting order, and ( ) is the cumulative unit normal density function, and .

Asymmetric Information Based Models

The asymmetric information based models explain market behaviour that does not rely only on
transaction costs, but also relies on asymmetric information. The essential feature of

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information-based models is that the trading process involves decisions made by traders who
have superior information compared to others. These informed traders buy when they know a
stock‟s current price is too low, and they sell when they know it is too high. From the market-
maker‟s point of view, the market-maker always loses with informed traders and bears the costs
of these trades; thus, the market-maker must be able to offset these losses from uninformed
traders. These gains arise from the bid-ask spread. Rational, competitive market-makers set their
bid and ask prices accordingly, and more extreme information asymmetries lead to wider bid-ask
spreads. Two main classes of asymmetric information models are the sequential trade models
and the strategic models.

Sequential Trade Models: In sequential trade models, randomly selected traders sequentially
arrive at the market. The framework is based on the assumption of the existence of differently
informed traders. Accordingly, there are so-called “informed traders”, who trade due to private
information on the fundamental value of the asset and “liquidity traders”, who trade due to
exogenous reasons, like portfolio adjustments or liquidity aspects. The assumption of
heterogeneous groups of traders provides the basis for a plethora of asymmetric information
based models. Seminal papers in this direction are Copeland and Galai (1983); Glosten and
Milgrom (1985); Easley and O'Hara (1987); O'Hara (2003); Hvitkjaer and O'Hara (2003) PIN
Model; Easley et al. (1997) and Easley et al. (2002) among others.

Copeland and Galai (1983) Model: The first attempt to formalise this concept of information
costs was by Copeland and Galai (1983) using a static one-trade framework. They assume that a
dealer who is risk neutral sets bid and ask prices to maximize expected profit; the market-maker
has unlimited capital; and there is no bankruptcy in the model. The most important contribution
of this study addresses the probabilistic structure. The market-maker knows that any given trade
comes from an informed trader with probability and from an uninformed trader with
probability ( ). The market-maker assumes that some uninformed traders will buy with the
probability of and sell with the probability of . Also, uninformed traders will not trade
with the probability of . The expected loss of the market-maker from trading with informed
traders is ( ) ( ), while the expected gain of the market-maker from trading with
uninformed traders is ( ) ( ) ( )where denotes ask price,
denotes bid price and denotes the true value of an asset. Since the market-maker does not

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know the type of trader he is dealing with, he weighs his expected gains and losses by the
probability of informed and uninformed trading. Namely, ( ) ( )
( )[ ( ) ( ) ( )] gives the market-maker‟s objective function to
maximize profit. This formula clearly shows that the size of bid and ask price is a function of the
market-maker‟s maximisation problem. Also, it shows that when the positive probability of
trading is by the informed trader, the bid-ask spread will always be larger than zero; otherwise
the market fails. This model provides an important characteristic of bid-ask spread, but it does
not involve multi-periods trading. More importantly, this model misses the point that the trade
itself could reveal the underlying information and so affect the behaviour of prices.

Glosten and Milgrom (1985) model: In the Glosten and Milgrom (1985) model, securities have
a payoff which is either high or low with given probability and is revealed after-market closure.
The population of traders consists of informed traders knowing the true asset payoff and
uninformed traders who buy or sell randomly with equal probability. Informed traders buy (sell)
if the true asset value is high (low). The proportion of informed traders in the market is given.
Dealers are uninformed and infer on the asset‟s true value based on the trade history. In
particular, observing a buy (sell) request of a trader, the dealer computes the conditionally
expected values of the asset given a trade is a buy or sell. Then, she sets the ask (bid) quote such
that the expected gain from an uninformed buyer (seller) are balanced by the loss to an informed
buyer (seller). After the next trade, the dealer updates her beliefs on the asset‟s true value using
her initial beliefs as priors. This results into updating recursions on the probabilities for the
asset‟s true values. The resulting bid-ask spread is a function of the asset‟s potential values (high
vs. low), their corresponding probabilities, and the relative proportion of informed traders.
Fundamental implications of this sequential trade model is that trade prices follow a martingale
– simply put, this means that the market maker‟s best prediction of future prices is current price,
order flow is correlated (buys tend to follow buys, sells tend to follow sells), bid-ask spreads
decline over time as the dealer‟s uncertainty is reduced and individual trades have price impact.

Glosten and Milgrom (1985) show that the ask price is greater and the bid price is less than the
expectation of , i.e. [ ] . The inequality is strict if adverse selection is possible.
Anything that increases adverse selection would increase spread: i.e. when the informed private
information becomes better; the ratio of informed to uninformed arrival rates is increased; the

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elasticity of uninformed supply and demand increases.

They also show in the model that the first difference of transaction price process is serially
uncorrelated. Thus the spreads due to monopoly power, transaction costs and risk aversion lead
to negative serial correlation, while spreads solely due to adverse selection do not.

The determination of the bid-ask spread in the Glosten-Milgrom model can be illustrated by
assuming that an asset can take on two possible values - a high value, , and a low value, -
with equal probability. Informed investors who know the correct value are present with
probability . Assuming risk neutrality, informed investors value the asset at ̅ ( )⁄ .
The ask price A is then the expected value of the asset conditional on trade at the ask price:

̅( )

The bid price is ̅( )

Since informed investors trade at the ask (bid) only if they believe the asset value is ( ), the
ask price exceeds the bid price.

The bid-ask spread, is given by: ( )

Where = the high value of an asset

= the low value of the same asset

= probability of informed investors' presence.

This model however did not adequately address how quickly prices will converge on
informational efficiency.

Easley - O'Hara (1987) Model: Using Glosten and Milgrom model as framework, Easley and
O‟Hara (1987) expanded it to take account of a strategic element of the dealer's dilemma. In this
model, both informed and uninformed investors can choose between trading large or small
volumes. If informed investors compete with one another, they will always want to trade large
volumes in order to maximise their profit. The dealer can therefore set a different spread since
those placing small orders pay no spread while investors making large trades have to pay a
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positive spread, especially as they are competing to exploit their private information before it is
revealed and reflected in prices. Easley and O'Hara (1987) develop a model demonstrating that
trade size also can affect trade price, not because of market makers' inventory imbalance, but
because block trades are correlated with adverse selection.

In their model, there are two risk neutral market makers that set the price and competition
ensures they each have zero expected profit. An information event about the asset occurs
before the trading day with probability ( ). The event contains a signal that the value
of the asset is either (with probability ) or (with probability ). According to the
signal, we have:

̅ [ | ]……………………………………………………………………………….. (1)

[ | ]…………………………………………………………………………………(2)

Assume is the fraction of trades made by the informed risk neutral traders. The market makers
and the uninformed traders do not know whether an information event has occurred, nor do they
observe the signal. But they do know the information event will eventually occur and the
information structure. So their initial unconditional expectation of the asset value is
( ) ̅ . They further assume the uninformed traders desire to buy (sell) ( ), ( )with
and . The fraction of uninformed traders for each trade quantity is
and . For market maker , she charges ( )for units and pays for
( ) for units. The two market makers play a simultaneous move game against each other.

There are two forms of equilibria that can occur: a separating equilibrium if informed traders
trade only large quantities; a pooling equilibrium if the informed trade either small or large
quantities with positive probability. This simple model explains why different trade quantities
face different prices, where the only friction is adverse selection.

Easley and O‘Hara (1992) Model: The Glosten and Milgrom (1985) model has been extended
and modified in various ways. Easley and O„Hara (1992) allow for event uncertainty by
assuming the random occurrence of a trade event at the beginning of each day. In case of no
information event, informed traders refrain from trading and only uninformed traders (randomly)

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trade in the market. Easley and O„Hara (1992) assume that uninformed traders do not necessarily
always buy or sell but can also refrain from trading. Consequently, also the occurrence of no
trade (i.e., a slowdown of the trading process) carries information. Therefore, besides bid-ask
spreads also the time between trades is informative. Variations of this framework are Easley and
O‟Hara (1987) where different order sizes are possible and Easley and O„Hara (1991) allowing
for different types of orders.

O'Hara (2003) Model: O'Hara (2003) showed that if information is asymmetrically distributed
and if those who do not have information know that others know more, there would be no
equilibrium price where everyone holds the market portfolio. Uninformed investors will hold a
per share of assets which informed investors expect to perform poorly. They will demand
compensation for this, and there will then no longer be a situation where idiosyncratic risk is
priced.

Easley, Hvitkjaer and O'Hara (2003) Probability of Informed Trading (PIN) Model:
Easley, Hvitkjaer and O'Hara (2003) considered the relationship between return and an estimate
of the Probability of Informed Trading (PIN). The PIN is estimated by looking at the
relationship between the number of buy and sell orders during the course of a day. If there are no
informed trades, this relationship should be close to 50/50. An excess of trades on one side of the
market suggests informed trading. This measure proves to have an economically and
strategically significant effect on return. They estimated that a 10% increase in PIN gives a 2.5%
increase in return.

Easley, Kiefer, O’Hara and Paperman (1996) and Easley, Hvidkjaer and O’Hara (2002):
Easley et al. (1997) and Easley et al. (2002) extend the framework of Easley and O„Hara (1992)
to allow for Poisson arrival of the events determining the asset‟s true value. Then, traders do not
sequentially arrive in discrete time but arrive randomly in continuous time. This arrival process
is governed by further Poisson processes with different intensities for informed and uninformed
traders. As a result, the numbers of daily buys and sells are jointly distributed based on a mixture
of Poisson distributions. Then, based on the information arrival intensity as well as the arrival
intensities for informed and uninformed traders, the probability of informed trading (PIN), that
is, the probability that a randomly chosen trader is informed can be computed. Easley, Engel,

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O’Hara and Wu (2008) extend this approach to a dynamic framework and estimate time-
varying PINs.

Strategic Trade Models: In a sequential trade model, a trader participates in a market only
once. Therefore, she does not take into account the impact of her trade decision on the
subsequent behavior of others. As a consequence, informed traders‟ trade largest possible
quantities as they do not have to account for possible adverse price effects in future trades. This
situation is completely different in a strategic trade model, where a trader repeatedly participates
in the market and therefore has to behave strategically. Seminal papers in this area include Kyle
(1985 and 1984); Admati and Pfleiderer (1988); Foster and Viswanathan (1990); Foster and
Viswanathan (1996), among others.

Kyle (1985) Model: The existence of private information in a market implies that informed
traders may have the incentive to act strategically to maximize profit, since the models allow
agents to time their trades or choose their trade size. Strategic behaviour was first analyzed by
Kyle (1985) in an important model of batch trading in securities market. In the Kyle model, the
security‟s value is stochastic but is known by an informed trader. Uninformed traders (“noise
traders”) trade independently of the asset‟s true value and submit a stochastic order flow. The
market maker receives the demand of both the uninformed and informed traders and has to set a
price such that all trades are cleared. However, as the informed trader might trade aggressively,
the market maker has to protect herself against being on the wrong side of the market by setting
the price as a linearly increasing function of the net order flow (i.e., the total net volume
requested by informed and uninformed traders). This however is anticipated by the informed
trader who computes her profits given her conjecture on the market maker‟s price setting rule
and her demand. In contrast to a sequential trade model, the informed trader‟s profit is not
necessarily positive as a high demand from liquidity traders might drive up the price set by the
market maker. The informed trader‟s optimization problem is to choose her demand such that her
expected profit is maximized. This yields a linear demand function in the asset‟s true value.
When the market maker conjectures the informed trader‟s underlying optimization problem, she
can compute the trader‟s linear demand function in dependence of the parameters of her own
price setting rule. This yields an inverse relationship between the slopes of the trader‟s demand
and the market maker‟s price setting rule (Kyle, 1985).

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The slope of the market maker‟s price setting rule determines the price impact of net order flow
and is commonly referred to as “Kyle‟s lambda”. Kyle (1985) makes this quantity operational by
exploiting properties of bivariate normal random variables. In such a framework, it can be
computed as a function of the covariance between the total asset demand and the true value of
the asset as well as the variance of noise trading. An implication of the Kyle model is that the
informed trader‟s expected profit is increasing in the divergence between the asset‟s true value
and the market maker‟s unconditional price (irrespective of the order flow) and in the variance
of noise trading. The latter effect is interesting as it implies that the informed trader‟s profit is
higher when there is more liquidity in the market. Kyle‟s model has been extended in various
directions. For instance, Admati and Pfleiderer (1988) and Foster and Viswanathan (1990) allow
for uninformed traders who behave strategically themselves. Foster and Viswanathan (1996),
among others, allow for multi-period models.

Admati - Pfleiderer Model of Uninformed Traders: In the previous strategic trader‟s model
considered, there was a restriction on informed traders who were not allowed to act strategically.
Instead, noise traders are assumed to transact every period for reasons exogenous to the model.
The reality however is that if it is profitable for an informed trader to time his trade, it must also
be profitable for an uninformed trader to do so as well. This suggests that to understand trade
patterns, the role of the uninformed must be specified in great details. In Admati and Pfleiderer
(1988) model, the focus was on the timing decisions of uninformed traders transacting within a
single day. These uninformed liquidity traders were assumed to be of two types. They comprised
the non-discretional liquidity traders who must transact a given amount at a specific time for
reasons exogenous to the model, and those who must trade an exogenously given amount, but
they have some discretion with respect to the timing of their trades. These discretionary traders
must satisfy their liquidity demands before the end of the trading day, but may choose when
during the day to submit their order. While the outcome of this model seems economically
plausible, it need not be the equilibrium that actually occurs. Indeed, it may be that numerous
other economically plausible equilibriums could occur, or that no equilibrium at all will arise.
Nevertheless, strategic models of trader behaviour can provide substantial insight and intuition
into the trading process,' and hence they may be useful in the analysis of specific problems
(O'Hara, 1995).

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Synthetic Model

Biais, Glosten, and Spatt (2005) propose an interesting synthetic model that incorporates both
the adverse selection and inventory/order handling cost. In the model, there are risk averse
informed traders and risk averse market makers (no uninformed traders for simplicity). The
informed trader is endowed with L shares of the risky asset and has observed a signal s on the
final value of the risky asset v. The market maker is endowed with I shares of the risky asset.
Assume and ( ) ( ). Also, assume market makers incur an
identical cost to trade shares.

The informed trader wants to submit a market order that maximizes her expected utility:

[ ( ( ) ( ) )| ] ( )

subject to

( ) [ (( ) )| ] ( )

It turns out the information revealed by the market order is equivalent to that contained

by the summary statistics: reflects the valuation of the strategic informed

trader for the asset, which is increasing in her private signal, and decreasing in her inventory.
Denote:

( )
( ) ( )

quantifies the relative weight of the noise and signal in the summary statistic . It also
measures the magnitude of the adverse-selection problem. For example, corresponds to
the case in which there is no private information.

As in Kyle (1985), if , there exists a perfect Bayesian equilibrium that:

[ ( )| ] ( ) ( )

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( )
( )

( )

( | )
( )

( | )
( )

When , i.e., there is no private information, the result is similar to Roll (1984), Ho and
Stoll (1981). Symmetrically, in the case where market makers are risk neutral ( ), and there
is no order handling cost ( ), we can obtain a specification similar to Kyle (1985), where
prices are equal to updated expectations of the value of the asset, conditional on the order flow.

4.0 Conclusion

This is the summary of existing literature related to market microstructure. According to the
review above, the market microstructure literature studies how the actual transaction process –
how buyers and sellers find one another and agree on a price – can affect price formation and
trading volumes in the market. Microstructure models differs from traditional financial models
by recognizing that legitimate information about companies fundamentals may be unequally
distributed between and differently interpreted by, market participants. We can therefore no
longer assume that prices will reflect information immediately even if all participants are
rational. The microstructure literature argues that both information risk due to asymmetric
information and difference in liquidity over time and between companies impact on long term
equilibrium prices in the market. We hope this study will help market participants to understand
how information risks due to asymmetric information and difference in liquidity over time and
between companies impact on long term equilibrium prices in the stock market.

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