Securities Markets: Trading Mechanisms, Liquidity, and Pricing

This course explains how financial securities are traded in real markets, and how the structure of the market affects:

  • price formation (market efficiency)
  • ease of trading (market liquidity)
  • investment policy (asset allocation).

In many finance courses, the mechanism of determining a security price is a black box, with no connection to the market in which the security is traded. By contrast, this course focuses on the actual market trading mechanism, as well as on the various market participants, and how these factors affect prices, liquidity and asset allocation.

As a result, this course also speaks to financial crises, and in particular explains why markets can suddenly become more inefficient, liquidity can dry up, and investors withdraw from the market.

In this course, we discuss in detail:

  • how trading frictions generate deviations of asset prices from their correct value, and how these inefficiencies are exploited (arbitrage
  • price formation when markets are designed as limit order markets, dealer markets, dark pools, call auctions, etc
  • how liquidity is defined in connection with trading costs and funding constraints, and how market design maximizes liquidity
  • how liquidity is affected by various market participants in the trading industry: the "buy‐side" (investors, asset managers, arbitrageurs), and the "sell‐side" (brokers, dealers, exchanges);
  • how liquidity affects the decisions of the various types of traders and investors, as well as their performance.

Course Objectives

When you complete this course, you should be able to understand:

  • Market efficiency and arbitrage. Are markets efficient, or are they dominated by irrational investors? Are prices predictable? How does price discovery work in the real world?
  • Market design. How do today’s complex securities markets operate? What is the difference between electronic limit order markets, dark pools, over‐the‐counter markets, call auctions?
  • Liquidity. What does it mean that a market is liquid? How is liquidity related to trading costs? What is the difference between market liquidity and funding liquidity?
  • Asset allocation in illiquid markets. How do we account for illiquidity and transaction costs in managing a portfolio? How does illiquidity affect performance, and the cost of capital?
  • High Frequency Trading (HFT). What are the strategies of High Frequency Traders? How do they affect liquidity? What is the connection with the Flash Crash of May 6, 2010?

Course Content

Market efficiency and arbitrage:

  • The role of information in market efficiency
  • Anomalies and behavioral finance
  • Arbitrage: exploiting market inefficiencies; arbitrage costs and risks

Trading Industry and Trading Mechanisms:

  • Trading and price discovery
  • Trading industry: key players
  • Trading mechanisms: limit order markets, OTC markets, dark pools

Illiquidity and Asset Management:

  • Liquidity: definition and connection with trading costs
  • Asset management in illiquid markets
  • New trends in investing and trading; High Frequency Trading