Market Microstructure

Q1. (4 marks)

• LOB: an electronic record of outstanding buy (bid) and sell (ask) limit orders, organised by price and time priority. (2 marks)
• Limit order: an order to buy/sell at a specified price or better; it provides liquidity and rests in the book. Market order: an order to trade immediately at the best available price; it consumes liquidity. (2 marks)

Q2. (4 marks)

• Depth = total quantity of orders available at (or within) given price levels; it measures how much can be traded without moving price. (2 marks)
• Cumulative depth (top 3 levels) $= 300 + 500 + 700 = 1500$ shares. (2 marks)

Q3. (5 marks)

• Absolute spread $= 50.30 - 50.20 = 0.10$. (2 marks)
• Mid-price $= (50.30 + 50.20)/2 = 50.25$. (1 mark)
• Relative spread $= \dfrac{0.10}{50.25} \times 10000 \approx 19.90$ bps. (2 marks)

Q4. (3 marks) — 1 mark each:

• Order-processing cost: fixed operational/clearing cost of providing quotes.
• Inventory-holding cost: compensation for risk of holding unwanted positions.
• Adverse-selection cost: compensation for trading against better-informed traders.

Q5. (4 marks)

• Adverse selection: the risk that a market maker trades with a counterparty who possesses superior (private) information about the asset's true value, so trades tend to move against the maker. (3 marks)
• Because informed order flow is systematically unprofitable for the maker, the maker widens the spread to recover losses on informed trades from uninformed traders. (1 mark)

Q6. (6 marks)

• Order fills: 400 @ 20.00, 500 @ 20.02, 300 @ 20.05 (only 300 of 600 needed to reach 1200). (2 marks)
• Total cost $= 400(20.00) + 500(20.02) + 300(20.05) = 8000 + 10010 + 6015 = 24025$. (2 marks)
• VWAP $= 24025 / 1200 \approx 20.0208$. (1 mark)
• Price impact $= \text{VWAP} - \text{best ask} = 20.0208 - 20.00 = 0.0208$ ($\approx 2.08$ cents). (1 mark)

Q7. (4 marks)

• Tick size: minimum allowable price increment for quotes. Lot size: minimum tradeable quantity unit. (2 marks)
• Reducing tick size: narrows the minimum achievable spread (tighter spreads), but tends to reduce displayed depth at the best price (thinner queues, more price levels). (2 marks)

Q8. (3 marks)

• Call auction: orders accumulate over a period and are executed together at a single clearing time (e.g., market open), rather than continuously. (2 marks)
• Rule: the auction/equilibrium price is set to maximise the executable volume (matched quantity). (1 mark)

Q9. (3 marks)

• Latency: the time delay between sending an order/receiving data and it being acted upon/received. (1.5 marks)
• Co-location: placing traders' servers physically inside/near the exchange's data centre to minimise latency and gain a speed advantage. (1.5 marks)

Q10. (4 marks)

• Iceberg order: a large limit order that displays only a small visible portion while keeping the remainder hidden, replenishing as slices execute. (1.5 marks)
• Dark pool: a private trading venue where orders are not publicly displayed pre-trade, allowing anonymous execution of large blocks. (1.5 marks)
• Difference: an iceberg is a hidden order within a lit exchange book, whereas a dark pool is an entirely separate off-exchange venue with no pre-trade transparency. (1 mark)

[
  {"claim":"Q2 cumulative depth top 3 = 1500","code":"result = (300+500+700)==1500"},
  {"claim":"Q3 relative spread approx 19.90 bps","code":"bps=(0.10/50.25)*10000; result = abs(bps-19.9004975)<1e-3"},
  {"claim":"Q6 VWAP approx 20.0208","code":"cost=400*20.00+500*20.02+300*20.05; vwap=cost/1200; result = abs(vwap-20.020833333)<1e-4"},
  {"claim":"Q6 price impact approx 0.0208","code":"cost=400*20.00+500*20.02+300*20.05; vwap=cost/1200; result = abs((vwap-20.00)-0.020833333)<1e-4"}
]