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Market Microstructure in Emerging and Developed Markets by Halil Kiymaz, H. Kent Baker

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CHAPTER 9

Designing a Trading Market

MASSIMILIANO MARZO

Associate Professor of Economics, University of Bologna

INTRODUCTION

Trading systems have evolved dramatically during the past years mainly because of the pressure emerging from two sources: regulation and technology. In the past, trading was mainly conducted on the trading floor where traders meet. Two main approaches to investment analysis prevailed: technical analysis and fundamental analysis. The first consists in studying the past price and volume changes to infer future evolution of prices. The type of trading strategy constructed on the basis of technical analysis is determined based on the evolution of the historical pattern of price-volume dynamics. By contrast, fundamental analysis focuses on underlying pricing models to infer the future evolution of prices. For equities, the fundamental models focus on the present value of future cash flows; for fixed income, the evaluation method focuses on the future path of market interest rates.

Recent technological advances have stressed the importance of algorithmic and electronic trading. This chapter explores the impact of these advances in the trading mechanisms. It analyzes trading mechanisms with special attention to new techniques introduced by high-frequency trading (HFT). Special attention is devoted to examining the most important trading algorithms.

The remainder of this chapter has seven sections. The first discusses the differences between active traders and passive ...

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