Financial Markets and Trading: An Introduction to Market Microstructure and Trading Strategies

CHAPTER 4

Market Microstructure:Information-Based Models

The idea behind the information-based models of market microstructure is that price is a source of information that investors can use for their trading decisions (see O'Hara 1995 and de Jong & Rindi 2009, for a detailed review). For example, if security price falls, investors may suggest that price will further deteriorate and refrain from buying this security. Note that such a behavior contradicts the Walrasian paradigm of market equilibrium, according to which demand grows (falls) when price decreases (increases).

The information-based models are rooted in the rational expectations theory. Namely, informed traders and market makers make conjectures on rational behavior of their counterparts, and they do 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. Obviously, informed investors trade only on one side of the market at any given time. The problem that market makers face while trading with informed investors is called adverse selection.

In this chapter, I consider two information-based models that were introduced for describing two different markets. The first is the Kyle's (1985) model, which was developed for batch auction markets. Another model is offered by Glosten & Milgrom (1985) to address the adverse selection problem ...