Forecasting Prices from Level-I Quotes in the Presence of Hidden Liquidity

Abstract:     
Bid and ask sizes at the top of the order book provide information on short-term price moves. Drawing from classical descriptions of the order book in terms of queues and order-arrival rates (Smith et al (2003)), we consider a diffusion model for the evolution of the best bid/ask queues. We compute the probability that the next price move is upward, conditional on the best bid/ask sizes, the hidden liquidity of the market and the correlation between changes in the bid/ask sizes. The model can be useful, among other things, to rank trading venues in terms of the "information content" of their quotes and to estimate the hidden liquidity in a market based on high-frequency data. We illustrate the approach with an empirical study of a few liquid stocks using quotes from various exchanges.

Number of Pages in PDF File: 10

Keywords: High frequency data, order book modeling, financial engineering, diffusion limit, hidden liquidity, market microstructure

JEL Classification: C44, C51, C32

Accepted Paper Series