Hostname: page-component-586b7cd67f-r5fsc Total loading time: 0 Render date: 2024-11-26T05:42:28.607Z Has data issue: false hasContentIssue false
  • English
  • Français

Liquidity and Information in Limit Order Markets

Published online by Cambridge University Press:  02 October 2019

Ioanid Roşu Open the ORCID record for Ioanid Roşu [Opens in a new window]
Ioanid Roşu*
Affiliation:
Roşu, [email protected], HEC Paris
*
Roşu (corresponding author), [email protected]
Get access Rights & Permissions [Opens in a new window]

Abstract

How does informed trading affect liquidity in limit order markets, where traders can choose between market orders (demanding liquidity) and limit orders (providing liquidity)? In a dynamic model, informed trading overall helps liquidity: A higher share of informed traders i) improves liquidity as proxied by the bid–ask spread and market resiliency, and ii) has no effect on the price impact of orders. The model generates other testable implications, and suggests new measures of informed trading.

Type
Research Article
Information
Journal of Financial and Quantitative Analysis , Volume 55 , Issue 6 , September 2020 , pp. 1792 - 1839
Copyright
Copyright © Michael G. Foster School of Business, University of Washington 2019

Access options

Get access to the full version of this content by using one of the access options below. (Log in options will check for institutional or personal access. Content may require purchase if you do not have access.)

Footnotes

I thank an anonymous referee, Hendrik Bessembinder (the editor), Peter DeMarzo, Doug Diamond, Thierry Foucault, Johan Hombert, Peter Kondor, Juhani Linnainmaa, Stefano Lovo, Christine Parlour, Talis Putnins, Uday Rajan, Pietro Veronesi, and finance seminar participants at Chicago Booth, Stanford University, University of California at Berkeley, University of Illinois Urbana-Champaign, University of Toronto (Dept. of Economics), Bank of Canada, HEC Lausanne, HEC Paris, University of Toulouse, Ecole Polytechnique, Tilburg University, Erasmus University, Insead, and Cass Business School, for helpful comments and suggestions. I am also grateful to conference participants at the 2010 Western Finance Association meetings, 2010 European Finance Association meetings, National Bureau of Economic Research (NBER) microstructure meeting, 4th Central Bank Microstructure Workshop, and the 1st Market Microstructure Many Viewpoints Conference in Paris.

References

Acharya, V., and Pedersen, L.. “Asset Pricing with Liquidity Risk.” Journal of Financial Economics, 77 (2005), 375–410.CrossRefGoogle Scholar
Admati, A., and Pfleiderer, P.. “A Theory of Intraday Patterns: Volume and Price Variability.” Review of Financial Studies, 1 (1988), 3–40.CrossRefGoogle Scholar
Amihud, Y., and Mendelson, H.. “Asset Pricing and the Bid–Ask Spread.” Journal of Financial Economics, 17 (1986), 223–249.CrossRefGoogle Scholar
Anand, A.; Chakravarty, S.; and Martell, T.. “Empirical Evidence on the Evolution of Liquidity: Choice of Market versus Limit Orders by Informed and Uninformed Traders.” Journal of Financial Markets, 8 (2005), 289–309.CrossRefGoogle Scholar
Back, K., and Baruch, S.. “Working Orders in Limit Order Markets and Floor Exchanges.” Journal of Finance, 62 (2007), 1589–1621.CrossRefGoogle Scholar
Bagehot, W.“The Only Game in Town.” Financial Analysts Journal, 27 (1971), 12–14 and 22.CrossRefGoogle Scholar
Bergin, J., and MacLeod, B.. “Continuous Time Repeated Games.” International Economic Review, 34 (1993), 21–37.CrossRefGoogle Scholar
Biais, B.; Hillion, P.; and Spatt, C.. “An Empirical Analysis of the Limit Order Book and the Order Flow in the Paris Bourse.” Journal of Finance, 50 (1995), 1655–1689.CrossRefGoogle Scholar
Biais, B.; Hombert, J.; and Weill, P.-O.. “Equilibrium Pricing and Trading Volume under Preference Uncertainty.” Review of Economic Studies, 81 (2014), 1401–1437.CrossRefGoogle Scholar
Bloomfield, R.; O’Hara, M.; and Saar, G.. “The ‘Make or Take’ Decision in an Electronic Market: Evidence on the Evolution of Liquidity.” Journal of Financial Economics, 75 (2005), 165–199.CrossRefGoogle Scholar
Brennan, M., and Subrahmanyam, A.. “Market Microstructure and Asset Pricing: On the Compensation for Illiquidity in Stock Returns.” Journal of Financial Economics, 41 (1996), 441–464.CrossRefGoogle Scholar
Brolley, M., and Malinova, K.. “Informed Trading in a Low-Latency Limit Order Market.” Working Paper, University of Toronto (2017).CrossRefGoogle Scholar
Chakravarty, S., and Holden, C.. “An Integrated Model of Market and Limit Orders.” Journal of Financial Intermediation, 4 (1995), 213–241.CrossRefGoogle Scholar
Cohen, K.; Maier, S.; Schwartz, R.; and Whitcomb, D.. “Transaction Costs, Order Placement Strategy, and Existence of the Bid–Ask Spread.” Journal of Political Economy, 89 (1981), 287–305.CrossRefGoogle Scholar
Collin-Dufresne, P., and Fos, V.. “Do Prices Reveal the Presence of Informed Trading?” Journal of Finance, 70 (2015), 1555–1582.CrossRefGoogle Scholar
Easley, D.; Hvidkjaer, S.; and O’Hara, M.. “Is Information Risk a Determinant of Asset Returns?” Journal of Finance, 57 (2002), 2185–2221.CrossRefGoogle Scholar
Foucault, T.“Order Flow Composition and Trading Costs in a Dynamic Limit Order Market.” Journal of Financial Markets, 2 (1999), 99–134.CrossRefGoogle Scholar
Foucault, T.; Kadan, O.; and Kandel, E.. “Limit Order Book as a Market for Liquidity.” Review of Financial Studies, 18 (2005), 1171–1217.CrossRefGoogle Scholar
Fudenberg, D., and Tirole, J.. Game Theory. Cambridge, MA: MIT Press (1991).Google Scholar
Glosten, L.“Is the Electronic Open Limit Order Book Inevitable?” Journal of Finance, 49 (1994), 1127–1161.CrossRefGoogle Scholar
Glosten, L., and Milgrom, P.. “Bid, Ask and Transaction Prices in a Specialist Market with Heterogeneously Informed Traders.” Journal of Financial Economics, 14 (1985), 71–100.CrossRefGoogle Scholar
Goettler, R.; Parlour, C.; and Rajan, U.. “Equilibrium in a Dynamic Limit Order Market.” Journal of Finance, 60 (2005), 2149–2192.CrossRefGoogle Scholar
Goettler, R.; Parlour, C.; and Rajan, U.. “Informed Traders and Limit Order Markets.” Journal of Financial Economics, 93 (2009), 67–87.CrossRefGoogle Scholar
Griffiths, M.; Smith, B.; Turnbull, A.; and White, R.. “The Costs and Determinants of Order Aggressiveness.” Journal of Financial Economics, 56 (2000), 65–88.CrossRefGoogle Scholar
Harris, L.“Optimal Dynamic Order Submission Strategies in Some Stylized Trading Problems.” Financial Markets, Institutions and Instruments, 7 (1998), 1–76.CrossRefGoogle Scholar
Harris, L., and Hasbrouck, J.. “Market versus Limit Orders: the Superdot Evidence on Order Submission Strategy.” Journal of and Financial and Quantitative Analysis, 31 (1996), 213–231.CrossRefGoogle Scholar
Hasbrouck, J.“Assessing the Quality of a Security Market: A New Approach to Transaction-Cost Measurement.” Review of Financial Studies, 6 (1993), 191–212.CrossRefGoogle Scholar
Hautsch, N., and Huang, R.. “The Market Impact of a Limit Order.” Journal of Economic Dynamics and Control, 36 (2012), 501–522.CrossRefGoogle Scholar
Hollifield, B.; Miller, R.; and Sandås, P.. “Empirical Analysis of Limit Order Markets.” Review of Economic Studies, 71 (2004), 1027–1063.CrossRefGoogle Scholar
Hou, K., and Moskowitz, T.. “Market Frictions, Price Delay, and the Cross-Section of Expected Returns.” Review of Financial Studies, 18 (2005), 981–1020.CrossRefGoogle Scholar
Huang, R., and Stoll, H.. “The Components of the Bid–Ask Spread: A General Approach.” Review of Financial Studies, 10 (1997), 995–1034.CrossRefGoogle Scholar
Jain, P.“Financial Market Design and the Equity Premium: Electronic versus Floor Trading.” Journal of Finance, 60 (2005), 2955–2985.CrossRefGoogle Scholar
Kaniel, R., and Liu, H.. “So What Orders Do Informed Traders Use?” Journal of Business, 79 (2006), 1867–1913.CrossRefGoogle Scholar
Kyle, A.“Continuous Auctions and Insider Trading.” Econometrica, 53 (1985), 1315–1335.CrossRefGoogle Scholar
Large, J.“A Market-Clearing Role for Inefficiency on a Limit Order Book.” Journal of Financial Economics, 56 (2009), 65–88.Google Scholar
Latza, T., and Payne, R.. “Forecasting Returns and Trading Equities Intra-Day Using Limit Order and Market Order Flows.” Working Paper, Cass Business School (2011).Google Scholar
Menkhoff, L.; Osler, C.; and Schmeling, M.. “Limit-Order Submissions Strategies under Asymmetric Information.” Journal of Banking and Finance, 34 (2010), 2665–2677.CrossRefGoogle Scholar
O’Hara, M.Market Microstructure Theory. Malden, MA: Blackwell Publishers (1995).Google Scholar
Pagnotta, E.“Information and Liquidity Trading at Optimal Frequencies.” Working Paper, New York University Stern School of Business (2013).Google Scholar
Parlour, C.“Price Dynamics in Limit Order Markets.” Review of Financial Studies, 11 (1998), 789–816.CrossRefGoogle Scholar
Parlour, C., and Seppi, D.. “Limit Order Markets: A Survey.” In Handbook of Financial Intermediation and Banking, Boot, A. W. A. and Thakor, A. V., eds. Elsevier Science (2008), 63–96.CrossRefGoogle Scholar
Pástor, Ľ., and Stambaugh, R.. “Liquidity Risk and Expected Stock Returns.” Journal of Political Economy, 111 (2003), 642–685.CrossRefGoogle Scholar
Roşu, I.“A Dynamic Model of the Limit Order Book.” Review of Financial Studies, 22 (2009), 4601–4641.CrossRefGoogle Scholar
Roşu, I.“Dynamic Adverse Selection and Liquidity.” Working Paper, HEC Paris (2019).CrossRefGoogle Scholar
Sandås, P.“Adverse Selection and Competitive Market Making: Empirical Evidence from a Limit Order Market.” Review of Financial Studies, 14 (2001), 705–734.CrossRefGoogle Scholar
Supplementary material: File

Roşu supplementary material

Internet Appendix

Download Roşu supplementary material(File)
File 1.2 MB