Financial Markets and Trading

Preface ix Acknowledgments xiii PART ONE Market Microstructure 1 CHAPTER 1 Financial Markets: Traders, Orders, and Systems 3 Traders 3 Orders 5 The Bid/Ask Spread 7 Liquidity 9 Market Structures 9 Continuous Order-Driven Markets 10 Oral Auctions 11 Call Auctions 12 Quote-Driven Markets and Hybrid Markets 13 CHAPTER 2 Modern Financial Markets 15 The U.S. Equity Markets 15 The NYSE 15 NASDAQ 16 Alternative Trading Systems 17 European Equity Markets 18 Spot FX Market 19 The U.S. Fixed Income Markets 21 High-Frequency Trading 22 CHAPTER 3 Inventory Models 26 Risk-Neutral Models 26 The Garman's Model 26 Amihud-Mendelson Model 29 Models with Risk Aversion 29 What Is Risk Aversion? 29 The Stoll's Model 31 CHAPTER 4 Market Microstructure: Information-Based Models 35 Kyle's Model 35 One-Period Model 35 Multi-Period and Multi-Insider Models 38 Glosten-Milgrom Model 39 Further Developments 41 CHAPTER 5 Models of the Limit-Order Markets 44 The CMSW Model 44 The Parlour Model 46 The Foucault Model 47 Equilibrium at Zero Volatility 48 Volatility Effect 49 New Developments 50 CHAPTER 6 Empirical Market Microstructure 53 Roll's Model 53 The Glosten-Harris Model 55 Structural Models 56 Recent Empirical Findings 58 Equity Markets 58 Global FX Spot Market 60 PART TWO Market Dynamics 63 CHAPTER 7 Statistical Distributions and Dynamics of Returns 65 Prices and Returns 65 The Efficient Market Hypothesis 66 Random Walk and Predictability of Returns 68 Recent Empirical Findings 69 Fractals in Finance 72 CHAPTER 8 Volatility 75 Basic Notions 75 Conditional Heteroskedasticity 77 Realized Volatility 79 Market Risk Measurement 81 CHAPTER 9 Agent-Based Modeling of Financial Markets 86 Adaptive Equilibrium Models 87 Non-Equilibrium Price Models 89 The Observable-Variables Model 91 Modeling Efficiency of Technical Trading 94 Modeling the Birth of a Two-Sided Market 95 PART THREE Trading Strategies 101 CHAPTER 10 Technical Trading Strategies 103 Trend Strategies 105 Filter Rules 105 Moving-Average Rules 106 Channel Breakouts 107 Momentum and Oscillator Strategies 109 Complex Geometric Patterns 113 CHAPTER 11 Arbitrage Trading Strategies 117 Hedging Strategies 118 Pair Trading 120 Cointegration and Causality 121 Pair Selection 123 Arbitrage Risks 125 CHAPTER 12 Back-Testing of Trading Strategies 129 Performance Measures 131 Resampling Techniques 133 Bootstrap 133 Markov Chain Monte Carlo 135 Random Entry Protocol 136 Comparing Trading Strategies 137 Bootstrap Reality Check 138 New Developments 139 CHAPTER 13 Execution Strategies 142 Benchmark-Driven Schedules 143 Cost-Driven Schedules 145 Risk-Neutral Framework 145 Risk-Averse Framework 147 The Taker's Dilemma 151 The Random Walk Model 153 Simulations of the Execution Costs 154 APPENDIX A Probability Distributions 156 Basic Notions 156 Frequently Used Distributions 159 The Uniform Distribution 159 The Binomial Distribution 159 The Poisson Distribution 160 The Normal Distribution 160 The Lognormal Distribution 161 The Cauchy Distribution 162 The Gamma Distribution 162 Stable Distributions and Scale Invariance 162 APPENDIX B Elements of Time Series Analysis 165 The Autoregressive Model 165 The Moving Average Model 167 The ARMA Model 168 Trends and Seasonality 170 Multivariate Time Series 172 Notes 174 References 180 About the Author 190 Index 191