A Stochastic Model for Order Book Dynamics
Imperial College London; CNRS - Universite de Paris VI
Cornell Financial Engineering Manhattan
Columbia University - Department of Industrial Engineering and Operations Research (IEOR)
September 24, 2008
We propose a stochastic model for the continuous-time dynamics of a limit order book. The model strikes a balance between three desirable features: it can be estimated easily from data, it captures key empirical properties of order book dynamics and its analytical tractability allows for fast computation of various quantities of interest without resorting to simulation. We describe a simple parameter estimation procedure based on high-frequency observations of the order book and illustrate the results on data from the Tokyo stock exchange. Using Laplace transform methods, we are able to efficiently compute probabilities of various events, conditional on the state of the order book: an increase in the mid-price, execution of an order at the bid before the ask quote moves, and execution of both a buy and a sell order at the best quotes before the price moves. Using high-frequency data, we show that our model can effectively capture the short-term dynamics of a limit order book. We also evaluate the performance of a simple trading strategy that is based on our results.
Number of Pages in PDF File: 23
Keywords: High frequency data, limit order book, financial engineering, Laplace transform
JEL Classification: C44, C51, C32working papers series
Date posted: September 26, 2008 ; Last revised: August 31, 2009
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