Market Microstructure Theory


  • Format: PDF
  • Pages: 291
  • Published Date: 1995


Market Microstructure Theory analyzes the development of microstructure theory from the initial inventory models through the information-based and game-theoretic paradigms of more recent research. This book provides a comprehensive guide to the theoretical work in this important area of finance.

Author’s Introduction:

Market Microstructure Theory began as the basis for a Ph.D. course in Market Microstructure that I taught at Cornell University. My motivation then, as it is now, was to provide a unified exposition and examination of the major models and theories used in market microstructure. These modeling issues are extensive, as microstructure has evolved from focusing primarily on inventorybased problems to being focused more recently on issues typically associated with information economics.

The literature has now developed to the point that there are several widely used paradigms, but the generality of their results, and hence their applicability, is not well understood. Moreover, the complexity of the models requires a familiarity with rational expectations
models, Bayesian learning, and game theory to appreciate their behavior. For both theorists and empirical researchers, there appeared a need for a unified treatment of market microstructure theory, whence the origins of this book.

In this development, I explain how the main theoretical models work, the evolution of the literature to that point, the strengths and weaknesses of each approach, and the issues left unaddressed. While this involves extensive discussion of the literature, the book is not intended to be the definitive literature survey of the area. My goal is the more modest (and more achievable) one of providing a general perspective on the development and evolution of market microstructure theory.

In pursuing this goal, I have chosen to focus on the topics that I find most interesting in the field. This has the somewhat unfortunate consequence that some work (particularly my own) is emphasized, while other work is perhaps not given the attention it deserves. My focus only on theoretical work also means that some of the most provocative work in market microstructure is not included simply because it is empirical in nature. I freely acknowledge these difficulties, and hope that the sheer dimension of the field provides at least some justification for these shortcomings.


  • Markets and Market Making
  • Inventory Models
  • Information-Based Models
  • Strategic Trader Models I: Informed Traders
  • Strategic Traikr Models II: Uninformed Traders
  • Infonnation and the Price Process
  • Market Viability and Stability
  • Liquidity and the Relationships Between Markets
  • Issues in Market Performance