Liquidity and Information in Order Driven Markets
HEC Paris - Finance Department
November 29, 2012
Does informed trading hurt liquidity? We address this question in a dynamic model of an order driven market with asymmetric information. In equilibrium, informed traders submit both market orders and limit orders, but market orders have a higher price impact than limit orders. Surprisingly, a higher share of informed traders (i) generates smaller bid-ask spreads, and (ii) has no effect on the price impact of orders. Competition among informed traders causes slippage - the fact that for an informed trader a limit order tends to execute at worse prices in the future. Slippage creates endogenous waiting costs for informed traders, and determines a novel component of the bid-ask spread. The model suggests several methods to estimate the probability of informed trading.
Number of Pages in PDF File: 60
Keywords: Bid-ask spread, price impact, information acquisition, volatility, trading volume, limit order book, waiting costs, slippage
JEL Classification: C7, D4, G1working papers series
Date posted: October 19, 2008 ; Last revised: March 13, 2013
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