The field of market microstructure is concerned with the study of financial markets on the microscopic scale. Thanks to the availability of high-frequency data that describes the temporal evolution of financial markets at the level of individual order arrivals and departures, the study of market microstructure has recently provided many new insights into several long-standing questions on diverse topics such as market efficiency, market stability, and the sources of volatility. The field is also highly relevant from a practical perspective, because a detailed understanding of market microstructure helps practitioners to design efficient execution strategies and to improve their estimation of risk exposure.
In this course, we will study how several widely observed but highly non-trivial mesoscopic- and macroscopic-scale properties of financial markets emerge from the microscopic-scale actions and interactions of individual traders. We will study in detail the process of trading via a limit order book, and contrast this mechanism to both open-outcry and quote-driven trading. We will introduce a mathematical framework for studying the temporal evolution of a limit order book, use this framework to discuss two recent limit order book models, and discuss how such models can help to illuminate the delicate interplay between order flow, liquidity, and price formation. Finally, we will observe that many properties of financial markets that were previously regarded as a direct result of traders' strategic actions may in fact emerge as a natural consequence of market microstructure.
Martin Gould