BFS 2002

Plenary Address

Microstructure and Asset Pricing

Maureen O'Hara, David Easley

Market microstructure analyzes the behavior and formation of prices in asset markets. Fundamental to this approach is the belief that features of the particular trading mechanisms used in markets are important in influencing the behavior of asset prices. The asset pricing literature also considers the behavior and formation of asset prices. This literature focuses on linking asset price dynamics to underlying economic fundamentals. While these two literatures share a common focus, they also share a common flaw: neither literature explicitly recognizes the importance and role of the factors so crucial to the other approach. Given the central importance of asset pricing in finance, a junction of these two very important literatures would seem beneficial.
In this article, we seek to foster this process by surveying the work linking microstructure factors to asset price dynamics. In the short run, these asset price dynamics involve issues such as the auto-correlation and cross-correlation structure of stocks, and we examine the literature relating these correlation structures to microstructure factors such as non-synchronous trading and dealer behavior. In the longer run, issues such as liquidity and the relation of private information to asset price dynamics dominate the research agenda. We survey the theoretical work linking microstructure factors to long run returns, and we review the empirical literature. Our goal is to highlight what is known and not known about the effect of microstructure variables on short-run and long-run asset price behavior. We also summarize what issues remain contentious, and suggest guidance for future research.