Essays on financial market microstructure.

Abstract

Understanding the forces for price formation and asset trading is the backbone of modern financial economics. In the oldest of adages, people trade because they differ---either informationally or from a risk sharing perspective. My thesis focuses on the former and investigates how asymmetric information affects the behavior of financial market participants, and through it, asset prices and trading volume. It is popular knowledge on Wall Street that volume moves prices. Recent empirical research further establishes an important role of the order imbalance in explaining this positive relation. The first essay of my thesis develops a new trading model that allows us to tractably capture the important relationships between trade volume, net order flow and price formation in models with heterogeneously informed agents. We hope that our setting will prove a workable model for answering a range of future questions about price formation in specialist markets. The second essay proposes a framework that affords a tractable analysis of possibly large economies of informationally heterogeneous individuals. Our model subsumes public and conditionally independent private signals as special cases, but captures far more, such as informational geography or social network effects. We provide and discuss multiple examples of the general structure, including curious paradoxes of the rational expectations equilibrium concept. Our framework is very general and naturally applies to environments that linearly aggregate private information. The third essay utilizes the aforementioned framework to further explore rational expectations equilibria with conditionally correlated information. We find that the behavior of prices and investors substantially differs from that in the world with conditionally independent signals. For instance, an agent's price impact is no longer solely determined by her signal's precision. We are also positioned to study how correlation affects trade. We find, in particular, that for a fixed precision of private information, signal correlation has a non-monotonic effect on price informativeness.Ph.D.Economic theoryFinanceSocial SciencesUniversity of Michigan, Horace H. Rackham School of Graduate Studieshttp://deepblue.lib.umich.edu/bitstream/2027.42/125827/2/3224693.pd