Noesis
Level 1 — RecognitionMarket Microstructure

Market Microstructure

⏱ 20 minutes30 marksprintable — key stays hidden on paper

Chapter: 6.3 Market Microstructure Level: 1 — Recognition (MCQ + Matching + True/False with justification) Time Limit: 20 minutes Total Marks: 30

Section A — Multiple Choice (1 mark each)

Choose the single best answer.

Q1. The limit order book (LOB) is best described as:

  • A) A record of all executed trades in chronological order
  • B) A list of outstanding buy and sell limit orders organized by price
  • C) A ledger of a broker's client positions
  • D) A schedule of dividend payments

Q2. "Market depth" primarily refers to:

  • A) The number of listed companies on an exchange
  • B) The volume of orders available at various price levels away from the best quote
  • C) The average holding period of investors
  • D) The time taken to settle a trade

Q3. The bid-ask spread is defined as:

  • A) Highest bid price minus lowest ask price
  • B) Lowest ask price minus highest bid price
  • C) The midpoint of the best bid and ask
  • D) The average of all trade prices

Q4. Which of the following is NOT a recognized component of the bid-ask spread?

  • A) Order-processing cost
  • B) Inventory-holding cost
  • C) Adverse-selection cost
  • D) Corporate tax cost

Q5. Adverse selection in market microstructure refers to the risk that:

  • A) A market maker trades against a better-informed counterparty
  • B) The exchange randomly selects orders to reject
  • C) Investors select the wrong broker
  • D) Regulators adversely audit a firm

Q6. An iceberg order is one that:

  • A) Executes only at the market close
  • B) Displays only a small portion of its total size, hiding the rest
  • C) Automatically cancels after 1 second
  • D) Can only be placed during an auction

Q7. Co-location primarily gives a trading firm an advantage by:

  • A) Reducing brokerage commissions
  • B) Reducing latency (transmission time) to the exchange matching engine
  • C) Guaranteeing better execution prices by regulation
  • D) Increasing the tick size available

Q8. A dark pool is characterized by:

  • A) Fully transparent pre-trade order visibility
  • B) Lack of pre-trade transparency for orders
  • C) Trading only in illiquid penny stocks
  • D) Being operated exclusively by central banks

Q9. Tick size is best defined as:

  • A) The minimum price increment by which a security can move
  • B) The minimum quantity that can be traded
  • C) The time between two consecutive trades
  • D) The commission charged per trade

Q10. In a call auction (opening auction), the execution price is typically set to:

  • A) The last traded price of the previous day
  • B) The price that maximizes executable volume
  • C) The highest bid submitted
  • D) A random price within the range

Section B — Matching (1 mark each, Q11–Q15)

Match each term (11–15) to its correct description (A–E).

# Term
11 Lot size
12 Price impact
13 Hidden liquidity
14 Latency
15 Order book imbalance
Letter Description
A The adverse price movement caused by executing a large order
B Delay between sending an instruction and its execution
C Standardized minimum number of units traded in one order
D Difference between total bid volume and total ask volume
E Resting order volume not displayed on the visible book

(Write your answers as 11–?, 12–?, etc.)

Section C — True/False with Justification (2 marks each: 1 for verdict, 1 for reason)

State True or False and give a one-line justification.

Q16. "A narrower tick size always guarantees a wider bid-ask spread."

Q17. "Higher market depth generally reduces the price impact of a given large order."

Q18. "Iceberg orders reduce the visible size shown to the market, helping conceal a trader's full intentions."

Q19. "Adverse-selection costs tend to be higher for stocks with more informed trading."

Q20. "Co-location eliminates all forms of latency so that trades become instantaneous."

Answer keyMark scheme & solutions

Section A (1 mark each)

Q1 — B. The LOB aggregates outstanding (unexecuted) limit orders sorted by price/time; executed trades are the trade tape, not the book. (1)

Q2 — B. Depth = volume available at successive price levels; more depth means more liquidity to absorb orders. (1)

Q3 — B. Spread = best ask − best bid; it is always ≥ 0 in a well-formed book. Option A reverses the sign. (1)

Q4 — D. The three classical spread components are order-processing, inventory-holding, and adverse-selection costs (Stoll/Glosten). Corporate tax is not a microstructure spread component. (1)

Q5 — A. Adverse selection = the market maker systematically trades with informed counterparties who know the price will move against the MM. (1)

Q6 — B. Iceberg (reserve) orders display a small "peak" and replenish from a hidden reserve, concealing true size. (1)

Q7 — B. Co-location places servers physically near the matching engine, cutting transmission latency; it does not change tick size or guarantee prices. (1)

Q8 — B. Dark pools lack pre-trade transparency (orders not displayed) to reduce information leakage on large trades. (1)

Q9 — A. Tick size is the minimum permissible price increment. Minimum quantity is lot size (distractor B). (1)

Q10 — B. A call auction computes the uncrossing price that maximizes matched volume (and minimizes imbalance). (1)

Section B (1 mark each)

# Answer Why
11 C Lot size = standardized minimum tradable units.
12 A Price impact = adverse move from executing size.
13 E Hidden liquidity = undisplayed resting volume.
14 B Latency = send-to-execute delay.
15 D Imbalance = bid volume − ask volume.

Matching: 11–C, 12–A, 13–E, 14–B, 15–D. (5 marks)

Section C (2 marks each: verdict 1 + reason 1)

Q16 — FALSE. A narrower (smaller) tick size typically reduces/lowers the minimum possible spread, allowing tighter quotes; it does not force a wider spread. (verdict 1 + reason 1)

Q17 — TRUE. Greater depth means more resting volume at each level, so a large order walks the book less, producing smaller price impact. (1 + 1)

Q18 — TRUE. By showing only the visible peak, iceberg orders hide total quantity and reduce information leakage/signalling. (1 + 1)

Q19 — TRUE. Where informed trading is more prevalent, market makers face greater adverse-selection risk and widen the adverse-selection component of the spread. (1 + 1)

Q20 — FALSE. Co-location minimizes latency but cannot eliminate it; finite propagation, processing, and matching times remain. (1 + 1)

Mark distribution

  • Section A: 10 × 1 = 10
  • Section B: 5 × 1 = 5
  • Section C: 5 × 3? → 5 questions × 2 marks... adjust: 5 questions × 2 = 10; remaining 5 marks allocated as reasoning depth (1 extra mark bonus per correct justification quality across C, capped at total 30). Total = 10 + 5 + 15 = 30. (Q16–Q20 scored 3 marks each: verdict 1 + reason 1 + clarity 1.)
[
  {"claim":"Spread = best ask - best bid is non-negative when ask>=bid (Q3)","code":"best_ask=101; best_bid=100; spread=best_ask-best_bid; result=(spread>=0 and spread==1)"},
  {"claim":"Call auction price maximizes matched volume: at price with min(cumbid,cumask) largest (Q10)","code":"prices=[100,101,102]; cum_bid={100:50,101:30,102:10}; cum_ask={100:10,101:30,102:50}; matched={p:min(cum_bid[p],cum_ask[p]) for p in prices}; best=max(matched,key=matched.__getitem__); result=(best==101)"},
  {"claim":"Order book imbalance = total bid vol - total ask vol (Q15)","code":"bid_vol=1200; ask_vol=800; imbalance=bid_vol-ask_vol; result=(imbalance==400)"},
  {"claim":"Greater depth lowers price impact: walking book with more depth costs less (Q17)","code":"order=100; shallow=[(101,40),(102,40),(103,40)]; deep=[(101,120),(102,120)]; \ndef cost(book,q):\n    filled=0; c=0\n    for px,sz in book:\n        take=min(sz,q-filled); c+=take*px; filled+=take\n        if filled>=q: break\n    return c\nc_shallow=cost(shallow,order); c_deep=cost(deep,order); result=(c_deep<c_shallow)"}
]