Chapter 12 Market microstructure

Abstract

This chapter discusses important aspects of the market microstructure literature and the theoretical approaches to the behavior of security prices and markets in the presence of differential information. The Walrasian (batch) market approach to modeling security market behavior in the presence of differential information is described. From this point of view there is a single market-clearing price set by some specified market intermediary. Because trades are aggregated and markets operate at specific points in time, this framework is closely related to rational expectations models. An alternative modeling approach is also presented– sequential trade model. In this model trades occur one at a time, different prices to buy and sell are quoted by a market specialist, and the sequence of orders may affect market behavior. From this point of view there is no market price; the price in any transaction will differ depending upon myriad factors such as whether the trade is large or small, the order arose from a buyer or seller, and the order is a limit or a market.

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