Chapter 2
Financial Markets
This chapter begins with a description of market price formation. The
notion of return that is widely used for analysis of the investment
efficiency is introduced in Section 2.2. Then the dividend effects on
return and the present-value pricing model are described. The next big
topic is market efficiency (Section 2.3). First, the notion of arbitrage is
defined. Then the Efficient Market Hypothesis, both the theory and
its critique, are discussed. The pathways for further reading in Section
2.4 conclude the chapter.
2.1 MARKET PRICE FORMATION
Millions of different financial assets (stocks, bonds, currencies,
options, and others) are traded around the world. Some financial
markets are organized in exchanges or bourses (e.g., New York
Stock Exchange (NYSE)). In other, so-called over-the-counter
(OTC) markets, participants operate directly via telecommunication
systems. Market data are collected and distributed by markets them-
selves and by financial data services such as Bloomberg and Reuters.
Modern electronic networks facilitate access to huge volumes of
market data in real time.
Market prices are formed with the trader orders (quotes) submitted
on the bid (buy) and ask (sell) sides of the market. Usually, there is a
5
spread between the best (highest) bid and the best (lowest) ask prices,
which provides profits for the market makers. The prices seen on the
tickers of TV networks and on the Internet are usually the transaction
prices that correspond to the best prices. The very presence of trans-
actions implies that some traders submit market orders; they buy at
current best ask prices and sell at current best bid prices. The trans-
action prices represent the mere tip of an iceberg beneath which prices
of the limit orders reside. Indeed, traders may submit the sell orders at
prices higher than the best bid and the buy orders at prices lower than
the best ask. The limit orders reflect the trader expectations of future
price movement. There are also stop orders designated to limit pos-
sible losses. For an asset holder, the stop order implies selling assets if
the price falls to a predetermined value.
Holding assets, particularly holding derivatives (see Section 9.1), is
called long position. The opposite of long buying is short selling, which
means selling assets that the trader does not own after borrowing
them from the broker. Short selling makes sense if the price is
expected to fall. When the price does drop, the short seller buys the
same number of assets that were borrowed and returns them to the
broker. Short sellers may also use stop orders to limit their losses in
case the price grows rather than falls. Namely, they may submit the
stop order for triggering a buy when the price reaches a predeter-
mined value.
Limit orders and stop orders form the market microstructure: the
volume-price distributions on the bid and ask sides of the market. The
concept market liquidity is used to describe price sensitivity to market
orders. For instance, low liquidity means that the number of securities
available at the best price is smaller than a typical market order. In this
case, a new market order is executed within a range of available prices
rather than at a single best price. As a result, the best price changes its
value. Securities with very low liquidity may have no transactions and
few (if any) quotes for some time (in particular, the small-cap stocks off
regular trading hours). Market microstructure information usually is
not publicly available. However, the market microstructure may be
partly revealed in the price reaction to big block trades.
Any event that affects the market microstructure (such as submis-
sion, execution, or withdrawal of an order) is called a tick. Ticks are
recorded along with the time they are submitted (so-called tick-by-tick
6 Financial Markets

Get Quantitative Finance for Physicists now with the O’Reilly learning platform.

O’Reilly members experience live online training, plus books, videos, and digital content from nearly 200 publishers.