11.

Market microstructure: information-

based models
11.1 Introduction
The idea: price is a source of information that investors can use for their
trading decisions. For example, if security price falls, investors may suggest
that price will further deteriorate and refrain from buying this security (which
contradicts the Walrasian framework).

Rational expectations: informed traders and market makers behave

rationally in the sense that all their actions are focused on maximizing their
wealth (or some utility function in the case of risk-averse agents). Market in
these models reaches an equilibrium state that satisfies participants
expectations.

Informed investors trade only on one side of the market at any given time.
Hence market makers face adverse selection problem.

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 11. Market microstructure: information-
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11.2 Kyles model for batch auction (1985)

11.2.1 One-period model

- single risky security with value v = N(p0, 02)
- risk-neutral informed trader (insider) submits strategic order of size x(v)
- several liquidity traders submit orders randomly with size y = N(0, y2)
- risk-neutral market maker (dealer) faces demand z = x + y and
assumes that clearing price is linear upon demand: p = z +
is inverse liquidity.

Expected insiders profit equals: E[x(p v)] = x(v x - ).

Then optimal insiders demand equals x = (v )/2.
In equilibrium, * = p0 and * = 0/2y

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 11. Market microstructure: information-
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11.2 Kyles model (continued)
Order flow from liquidity traders distorts the insiders information: even if
insider knows that the traded security is overpriced and hence is not
interested in buying it, a large idiosyncratic buy order from a liquidity trader will
motivate the dealer to increase price.

Insiders profit = loss of liquidity traders = 0.5y0

Dealers profit = 0 (Bertrands competition model)
Why would anyone run batch auction?

Multi-period model: K auctions at times tk = kt = k/K

Liquidity trading volume: yk = N(0, y2t)
Insiders demand: xk = k(v - pk) t
Dealers price: pk = pk-1 + k(xk + yk)
No analytical solution
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 11. Market microstructure: information-
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11.3 Glosten-Milgrom model for a continous market (1985)
(see Hasbrouck (2007))
Sequential trading model: risk-neutral dealer trades with insiders arriving with
probability and liquidity traders with probability 1 - , one unit at a time. Security
can have two values: high vH (good news) with probability 1- and low vL (bad news)
with probability . Insiders trade according to news but liquidity traders buy and sell
with probability of 0.5.

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 11. Market microstructure: information-
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11.3 Glosten-Milgrom model (continued)
Dealer sets regret-free prices, i.e. these prices are dealers expectations of
the securitys value based on trading signals (B=buy, S=sell)
ask price a = E[V | B] = VL Pr(V= VL | B) + VH Pr(V=VH | B)
bid price b = E[V | S] = VL Pr(V= VL | S) + VH Pr(V=VH | S)

Pr( B | A)
Pr( A)
Bayes rule: Pr(A|B) = Pr( B )

Pr(B) = Pr(V= VL)Pr(B |V= VL) + Pr(V= VH)Pr(B |V= VH) = 0.5(1 + (1-2))

Pr( B | V VL )
Pr(V= VL|B) = Pr(V VL )
Pr( B)

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 11. Market microstructure: information-
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11.3 Glosten-Milgrom model (continued 2)
(1 )VL (1 )(1 )VH
ask =
1 (1 2 )

bid = (1 )VL (1 )(1 )VH

1 (1 2 )

spread = 4 (1 ) (VH VL ) => (VH -VL) when = 0.5

1 (1 2 ) 2 2
Spread grows with the number of insiders: adverse selection

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 11. Market microstructure: information-
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11.4 Extensions of Glosten-Milgrom model
Easley & OHara (1987; 1992); Subrahmanyam (1991); Back & Baruch (2004)

- No-news case: only liquidity traders trade => decreases spread.

- Orders of small and large sizes. Large orders yield higher gains to
informed traders but reveal their private information to the market.
On the other hand, small orders help to hide some private information and
improve price for large orders. Hence informed traders face a choice
between trading exclusively large orders and mixing them with small
ones.

- Multiple insiders. With their growing number, liquidity first decreases due to
risk aversion. However, with further number growth, liquidity starts increasing.

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 11. Market microstructure: information-
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11.4 Summary
Price is a source of information that investors can use for their trading
decisions. For example, if security price falls, investors may suggest that price
will further deteriorate and refrain from buying this security.
Market makers face adverse selection problem while trading with informed
investors who trade only on one side of the market at any given time.
Dealers and informed investors behave rationally, i.e. make trading decisions to
maximize their wealth (or utility function depending on wealth in case risk-averse
agents). As a result, price converges to some equilibrium value that satisfies
rational expectations.
In the batch auctions, dealers compensate potential losses from adverse
selection by setting asset price increasing with demand (Kyles model (1985).
In the sequential trade models, dealers compensate potential losses from
adverse selection by setting the bid/ask spread that grows with the number of
informed traders and with order size (Glosten-Milgrom model (1985)).
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