Financial Markets and Trading An Introduction

Financial Markets and Trading Strategies covers three main parts: Market organization and microstructure theory, which will contain an overview of modern financial markets for equities, FX, and fixed income. There will be a description on various market types and market price formation with different types of traders and orders. Major theoretical microstructure models will be presented, as also concepts of the agent-based modeling of financial markets and important empirical properties of equity and FX markets. Common trading strategies and back-testing will summarize the concepts used in technical analysis and arbitrage trading (such as pairs trading and mean-reversion strategies). There will be a description of performance criteria and back-testing of trading strategies with re-sampling techniques and an outline of other ideas used in optimal order execution, such as optimal order slicing and maker-versus-taker strategies. The appendix will include Probability distributions and time series analysis. For self-contained presentation, there will be a description of the mathematical methods used in formulating trading strategies and their back-testing. There will be a focus on the linear regression, autoregressive and moving average models, trends, co-integration, and conditional heteroskedasticity. There will also be an introduction to resampling techniques, such as bootstrap and MCMC.

Dr. Anatoly B. Schmidt holds a master of science and PhD in physics from University of Latvia. He has been working as a quantitative analyst in the financial industry since 1997. Dr. Schmidt has published several papers on agent-based modeling of financial markets, market microstructure, and algorithmic trading as well as a book entitled Quantitative Finance for Physicists: An Introduction. He also teaches in the Financial Engineering Program of Stevens Institute of Technology.

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

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

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