Chapter 7 Quiz
Test your understanding of order books, the continuous double auction, matching rules, and market quality metrics.
Question 1
What is the bid-ask spread in an order book?
- A) The difference between the highest and lowest trade prices of the day
- B) The difference between the best (lowest) ask price and the best (highest) bid price
- C) The average of all bid and ask prices in the book
- D) The difference between the last trade price and the midpoint
Answer
**B) The difference between the best (lowest) ask price and the best (highest) bid price.** The spread measures the gap between the highest price a buyer is willing to pay and the lowest price a seller is willing to accept. It represents the cost of immediacy -- the price you pay for executing a trade right now rather than waiting.Question 2
In a continuous double auction with price-time priority, which resting sell order gets matched first against an incoming buy?
- A) The sell order with the largest quantity
- B) The sell order that arrived most recently
- C) The sell order with the lowest price; if tied, the one that arrived earliest
- D) The sell order closest to the midpoint price
Answer
**C) The sell order with the lowest price; if tied, the one that arrived earliest.** Price-time priority means that price always takes precedence. Among orders at the same price, time priority (FIFO) determines which is matched first. This incentivizes traders to offer competitive prices and rewards those who commit to their orders early.Question 3
A trader submits a buy limit order at $0.55 when the best ask is $0.57. What happens?
- A) The order is rejected because it is below the best ask
- B) The order executes immediately at $0.57
- C) The order is added to the bid side of the book at $0.55, waiting for a matching sell
- D) The order executes at the midpoint of $0.56
Answer
**C) The order is added to the bid side of the book at $0.55, waiting for a matching sell.** Since the buy price ($0.55) is less than the best ask ($0.57), the prices do not cross and no match occurs. The limit order rests in the book as a passive (maker) order until a sell order at $0.55 or lower arrives.Question 4
What is the difference between a maker and a taker?
- A) Makers buy contracts; takers sell contracts
- B) Makers place orders that rest in the book (add liquidity); takers place orders that match immediately (remove liquidity)
- C) Makers trade in large quantities; takers trade in small quantities
- D) Makers use limit orders; takers use stop orders
Answer
**B) Makers place orders that rest in the book (add liquidity); takers place orders that match immediately (remove liquidity).** The maker/taker distinction is about whether an order provides liquidity (rests in the book for others to trade against) or consumes liquidity (immediately matches against resting orders). Many exchanges charge lower fees to makers to incentivize liquidity provision.Question 5
In a prediction market where contracts pay $1.00 or $0.00, what is the maximum rational bid price?
- A) $0.50
- B) $0.99
- C) $1.00
- D) There is no maximum
Answer
**C) $1.00.** A rational trader would never pay more than $1.00 for a contract that can pay at most $1.00. In practice, bids very close to $1.00 (e.g., $0.99) indicate near certainty that the event will occur. The theoretical maximum is $1.00, though most platforms restrict prices to the open interval ($0.01 to $0.99).Question 6
What does walking the book mean?
- A) Cancelling all orders on one side of the book
- B) A large order executing at progressively worse prices as it consumes liquidity at multiple price levels
- C) A market maker adjusting quotes up and down throughout the day
- D) Reconstructing historical order book data from trade records
Answer
**B) A large order executing at progressively worse prices as it consumes liquidity at multiple price levels.** When a large market order (or aggressive limit order) is bigger than the quantity available at the best price, it "walks" through successive price levels, filling at each level until fully executed. The result is slippage -- the average execution price is worse than the best price at the time of submission.Question 7
What happens when a FOK (Fill or Kill) order cannot be completely filled?
- A) It is partially filled and the rest is cancelled
- B) It is entirely cancelled with no execution
- C) It rests in the book until it can be fully filled
- D) It converts to a market order
Answer
**B) It is entirely cancelled with no execution.** FOK requires complete, immediate execution. If the full quantity cannot be matched right away, the entire order is killed. This is unlike IOC (Immediate or Cancel), which allows partial fills and only cancels the unfilled remainder.Question 8
A depth chart shows a large, flat step on the bid side at $0.45. What does this indicate?
- A) No one wants to buy below $0.45
- B) A large concentration of buy orders at $0.45, creating a potential support level
- C) The market will definitely not drop below $0.45
- D) The midpoint price is $0.45
Answer
**B) A large concentration of buy orders at $0.45, creating a potential support level.** Large order clusters create "walls" in the depth chart. A large bid wall at $0.45 means significant buying interest at that price, which may prevent the price from falling below that level. However, these orders can be cancelled at any time, so the support is not guaranteed.Question 9
Which of the following is TRUE about market orders in prediction markets?
- A) They guarantee a specific execution price
- B) They guarantee execution (assuming sufficient liquidity) but not price
- C) They are always cheaper than limit orders
- D) They rest in the order book if not immediately matched
Answer
**B) They guarantee execution (assuming sufficient liquidity) but not price.** Market orders prioritize speed of execution over price. They will match against whatever resting orders are available, starting from the best price. In illiquid prediction markets, this can lead to significant slippage if the order is large relative to available depth.Question 10
At what price does a trade execute when an incoming buy order matches a resting sell order?
- A) The buy order's price
- B) The sell order's price (the resting order's price)
- C) The average of the two prices
- D) The midpoint price at the time of matching
Answer
**B) The sell order's price (the resting order's price).** In a standard continuous double auction, the trade price is always the resting order's price. The incoming (aggressive) order is the one crossing the spread, and the resting order's price is honored. This incentivizes early order placement and ensures fair treatment of passive liquidity providers.Question 11
What is slippage?
- A) The time delay between order submission and execution
- B) The difference between the expected execution price and the actual average execution price
- C) A type of order that triggers at a specific price
- D) The spread between the best bid and ask
Answer
**B) The difference between the expected execution price and the actual average execution price.** Slippage occurs when a large order consumes liquidity at multiple price levels, resulting in an average execution price worse than the initially quoted price. It is particularly relevant in prediction markets, where thinner liquidity means even moderate-sized orders can experience significant slippage.Question 12
What is pro-rata matching?
- A) Matching orders proportionally to their size at the same price level, rather than by time priority
- B) Matching the most profitable orders first
- C) Matching orders in random order
- D) Matching orders alphabetically by trader name
Answer
**A) Matching orders proportionally to their size at the same price level, rather than by time priority.** Under pro-rata matching, if three orders at the same price have sizes 100, 200, and 300 (total 600), and an incoming order for 300 contracts arrives, the allocation would be 50, 100, and 150 respectively. This contrasts with price-time priority, where the earliest order would be fully filled first.Question 13
What is the order book imbalance (OBI), and what does a positive value indicate?
- A) OBI = (ask_depth - bid_depth) / total_depth; positive means more selling interest
- B) OBI = (bid_depth - ask_depth) / total_depth; positive means more buying interest
- C) OBI = bid_price / ask_price; positive means prices are increasing
- D) OBI = number of buys / number of sells; positive means more buy orders
Answer
**B) OBI = (bid_depth - ask_depth) / total_depth; positive means more buying interest.** Order book imbalance ranges from -1 (all ask depth, no bid depth) to +1 (all bid depth, no ask depth). A positive OBI suggests more buying pressure, which research has shown to be a short-term predictor of upward price movement, especially when measured at the best bid and ask levels.Question 14
What is VWAP and why is it useful?
- A) Volume-Weighted Average Price; it is the benchmark for determining if you got a good execution price
- B) Variable Width Average Pricing; it measures spread volatility
- C) Verified Weighted Auction Price; it is the official closing price
- D) Volume-Weighted Ask Price; it tracks only the sell side
Answer
**A) Volume-Weighted Average Price; it is the benchmark for determining if you got a good execution price.** VWAP = sum(price_i * quantity_i) / sum(quantity_i) for all trades. If you bought below VWAP, you paid less than the average market participant. VWAP is widely used as an execution quality benchmark in both traditional finance and prediction markets.Question 15
Which of the following is NOT a characteristic that distinguishes prediction market order books from traditional stock order books?
- A) Prices are bounded between $0 and $1
- B) Liquidity is typically thinner
- C) Price-time priority matching is used
- D) Spreads are typically wider
Answer
**C) Price-time priority matching is used.** Price-time priority is the standard matching algorithm used in both prediction markets and traditional stock exchanges. The other three options -- bounded prices, thinner liquidity, and wider spreads -- are genuine differences between prediction market order books and traditional stock order books.Question 16
What is spoofing in the context of an order book?
- A) Creating fake accounts to trade with yourself
- B) Placing large orders with the intent to cancel them before execution, to manipulate other traders' behavior
- C) Submitting orders faster than other participants
- D) Trading on insider information
Answer
**B) Placing large orders with the intent to cancel them before execution, to manipulate other traders' behavior.** Spoofing involves placing large, visible orders to create the illusion of buying or selling pressure, then cancelling them before they can be executed. The goal is to trick other traders into moving the price, allowing the spoofer to profit. This practice is illegal in regulated US securities markets.Question 17
What is the difference between Level 1 and Level 2 market data?
- A) Level 1 shows only the last trade price; Level 2 shows bid and ask prices
- B) Level 1 shows the best bid/ask (top of book); Level 2 shows the full depth at all price levels
- C) Level 1 is real-time; Level 2 is delayed
- D) Level 1 is free; Level 2 requires payment
Answer
**B) Level 1 shows the best bid/ask (top of book); Level 2 shows the full depth at all price levels.** Level 1 data provides the most basic market information: best bid, best ask, last trade, and volume. Level 2 data reveals the entire order book with quantities at every price level, giving traders a much more complete picture of market supply and demand.Question 18
Why do prediction markets typically have wider spreads than major stock markets?
- A) Prediction markets are more heavily regulated
- B) Prediction markets have higher volumes
- C) Prediction markets have thinner liquidity, fewer market makers, and event-driven uncertainty
- D) Prediction market contracts are more expensive
Answer
**C) Prediction markets have thinner liquidity, fewer market makers, and event-driven uncertainty.** Wider spreads in prediction markets result from several factors: lower trading volumes mean less competition among market makers, fewer participants overall, the binary payoff structure creates unique hedging challenges, and event-driven dynamics can introduce sudden uncertainty. Typical prediction market spreads are 1-5 cents, compared to fractions of a penny for major stocks.Question 19
A stop-loss sell order at $0.40 on a prediction market contract you own at $0.55 will:
- A) Immediately sell your contract at $0.40
- B) Trigger a sell order if the price drops to $0.40 or below
- C) Guarantee you will sell at exactly $0.40
- D) Cancel your existing buy order at $0.55
Answer
**B) Trigger a sell order if the price drops to $0.40 or below.** A stop-loss order remains dormant until the trigger price is reached. When the last trade price hits $0.40, the stop converts to either a market sell (stop-market) or a limit sell (stop-limit). Note that the actual execution price may be worse than $0.40, especially in illiquid markets where the price can gap through the stop level.Question 20
An iceberg order shows 100 contracts but has a total hidden size of 2,000 contracts. Why would a trader use this?
- A) To get lower trading fees
- B) To reduce market impact by not revealing their full trading intention
- C) To ensure faster execution
- D) To avoid paying the spread
Answer
**B) To reduce market impact by not revealing their full trading intention.** If a trader shows a 2,000-contract order, other participants will likely front-run it -- buying ahead to sell at higher prices. By revealing only 100 contracts at a time, the trader conceals their true size and reduces the chance that the market moves against them before their order is fully executed.Question 21
The Lee-Ready algorithm classifies a trade as buyer-initiated when:
- A) The trade quantity is greater than 100
- B) The trade price is above the midpoint at the time of the trade
- C) The trade occurs on the bid side of the book
- D) The buyer placed the order before the seller
Answer
**B) The trade price is above the midpoint at the time of the trade.** The Lee-Ready algorithm infers trade direction by comparing the trade price to the midpoint. If the price is above the midpoint, the trade likely resulted from a buyer crossing the spread (hitting the ask), so it is classified as buyer-initiated. If the price equals the midpoint, the algorithm falls back to the "tick test" -- comparing to the previous trade price.Question 22
What does "depth at best" measure?
- A) The total number of orders in the book
- B) The total quantity available at all price levels
- C) The quantity available at the best bid and best ask prices
- D) The number of price levels in the book
Answer
**C) The quantity available at the best bid and best ask prices.** Depth at best tells you how much you can trade at the currently quoted prices without moving the market. A high depth at best suggests the quotes are robust; a low depth at best suggests even small orders might exhaust the available liquidity at the best prices.Question 23
In the context of prediction markets, what is the primary advantage of an order book (CLOB) over an automated market maker (AMM)?
- A) Lower technology requirements
- B) Better price discovery through competition among traders
- C) No need for any liquidity providers
- D) Guaranteed zero spread
Answer
**B) Better price discovery through competition among traders.** Order books allow prices to be determined by the actual supply and demand of participants. When multiple market makers compete, they naturally tighten the spread and move prices toward fair value more efficiently than a formula-based AMM. This is particularly valuable when informed traders are present, as their orders directly influence the order book.Question 24
A prediction market contract has a best bid of $0.80 and a best ask of $0.85. What is the relative spread?
- A) $0.05
- B) 5.0%
- C) 6.06%
- D) 6.25%
Answer
**C) 6.06%.** Relative spread = (ask - bid) / midpoint = ($0.85 - $0.80) / (($0.85 + $0.80) / 2) = $0.05 / $0.825 = 0.0606 = 6.06%. The absolute spread is $0.05, but the relative spread (6.06%) normalizes by the midpoint price. This makes it possible to compare spreads across contracts trading at different price levels.Question 25
You are watching an order book for an election prediction market. Suddenly, you observe: (1) all asks near the current price are cancelled, (2) aggressive bids appear at higher prices, (3) the spread widens temporarily, then (4) new quotes appear at a much higher price level. What most likely happened?
- A) A market maker experienced a technical failure
- B) A large seller entered the market
- C) New information arrived that increased the perceived probability of the event
- D) The exchange halted trading