RFS Advance Access originally published online on April 2, 2009
Review of Financial Studies 2009 22(11):4601-4641; doi:10.1093/rfs/hhp011
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A Dynamic Model of the Limit Order Book
uUniversity of Chicago
Send correspondence to Ioanid Rou, Booth School of Business, University of Chicago, 5807 South Woodlawn Avenue, Chicago, IL 60637; telephone: 773-834-1826; fax: 773-834-0944. E-mail: irosu{at}uchicago.edu.
JEL Classification: C7, D4, G1
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Abstract |
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This paper presents a model of an order-driven market where fully strategic, symmetrically informed liquidity traders dynamically choose between limit and market orders, trading off execution price and waiting costs. In equilibrium, the bid and ask prices depend only on the numbers of buy and sell orders in the book. The model has a number of empirical predictions: (i) higher trading activity and higher trading competition cause smaller spreads and lower price impact; (ii) market orders lead to a temporary price impact larger than the permanent price impact, therefore to price overshooting; (iii) buy and sell orders can cluster away from the bid-ask spread, generating a hump-shaped order book; (iv) bid and ask prices display a comovement effect: after, e.g., a sell market order moves the bid price down, the ask price also falls, by a smaller amount, so the bid-ask spread widens; (v) when the order book is full, traders may submit quick, or fleeting, limit orders.
The author thanks Rob Battalio, Shane Corwin, Thierry Foucault, Drew Fudenberg, Xavier Gabaix, Larry Glosten, Burton Hollifield, Sergei Izmalkov, Eugene Kandel, Leonid Kogan, Jon Lewellen, Juhani Linnainmaa, Andrew Lo, David Musto, Stew Myers, Jun Pan, Christine Parlour, Anna Pavlova, Duane Seppi, Chester Spatt, Richard Stanton, Dimitri Vayanos, and Jiang Wang for helpful comments and suggestions. He is also grateful to participants at the NBER meeting, May 2004; WFA meeting, June 2005; and to seminar audiences at MIT, Berkeley, Notre Dame, Toronto, Kellogg, Carnegie Mellon, Michigan, Wharton, and Chicago.