Liquidity, Markets and Trading in Action

Economics encompasses two broad subjects: macroeconomics and microeconomics. Macroeconomics deals with an economy in aggregate and addresses issues such as inflation, unemployment, interest rates, and economic growth. We present a macroeconomic perspective in Chap. 3. Microeconomics, the focus of this chapter, operates, as its name indicates, on the micro level, addressing household consumption decisions and the production decisions of firms. In this chapter, we focus on the parallels (and a few differences) between a standard microeconomics formulation (a household’s selection of an optimal consumption bundle) and a standard finance model (an investor’s selection of a portfolio that optimally combines a riskless asset – cash – and a risky equity portfolio). The finance formulation is the Capital Asset Pricing Model (CAPM). CAPM is a keystone of what is known as modern portfolio theory, the originator of which is Harry Markowitz who was awarded a Nobel Memorial Prize in Economic Sciences in 1990 for having developed the theory of portfolio choice. We then introduce friction (trading costs) and show how CAPM’s frictionless market equilibrium is perturbed. The analysis provides a good lead-in to the next chapter on finance. 

Trading is the implementation of an investment decision. After a portfolio decision has been made by a portfolio manager, it must be implemented, and especially for handling large orders and navigating stressful markets, specific skills and responsibilities are needed that require the expertise of a professional trader. However, the efficiency with which orders are handled and turned into trades depends, not just on traders’ abilities, but also on a market’s liquidity, on the design of the marketplace where shares are traded, and on the regulatory environment. In this chapter, we cover trading costs, liquidity, volatility, price discovery, market structure, and market structure regulation.

This chapter explains how “information shocks” can affect the liquidity of financial markets and stock prices. The focus is on unexpected macroeconomic news as a key type of information shock. The final portion of the chapter discusses some realworld events that demonstrate the effects of these shocks on financial markets and how investors react to unexpected macroeconomic news items.

Financial markets today are highly computerized -- from software-driven order submission to price determination to straight-through clearing and settlement -- computer technology has displaced manual activities and streamlined functions throughout the trading value chain. The previous chapters examined microeconomic principles that underpin trading and price-setting, and finance theory that provides analytical frameworks for market outcomes. Our analysis introduces real market frictions and examines how transactions costs and heterogeneity among market participants makes market structure and tracing mechanism design crucial determinants of market outcomes and behavior. . In this chapter, we drill down further into the realities of a non-frictionless market in order to focus on how technology can enhance the efficiency of an actual marketplace. Challenging market design issues are encountered when developing and operating an actual trading facility, and as IT professionals know, the devil is in the details. The practical considerations in operating a market system successfully are the next topic this book addresses. 

Trading education is vital for success in the securities and investments industry. Are apprenticeships and time on an institutional trading desk the only way to learn how to trade? Do you need to work with real orders and have real money at risk to gain experience interacting with the dynamic process of price formation? The answers are no and no. Trading simulations that are well-designed can create experiences with price discovery and impose the challenges of illiquidity in ways that replicate the learning accomplished (and pressures felt) on a real trading desk. With TraderEx, you will appreciate the complexity of trading and understand it as a distinct profession within the financial industry, even if it is not always thought of as such in business school curriculum.