Does the Open Limit Order Book Matter in Explaining Informational Volatility?

Abstract:     
This paper evaluates the informational content of the open limit order book by studying its role in explaining the volatility of the efficient price. We separate liquidity-driven (transitory) volatility from information-driven (efficient) volatility using a dynamic state-space co-integration model for ask and bid quotes. We show that illiquid books precede an increase in the intensity of information arrival, even after controlling for the incoming order flow. Consistently with Foucault et al.'s (2007, Review of Financial Studies) model, for any given trade size, the higher the round-trip costs, the higher the posterior informational volatility. We show that other pieces of the LOB, such as quoted depth, both at and away from the best quotes, and the book imbalance, are also informative. Therefore, the state of the book is a channel for volatility information.

Number of Pages in PDF File: 40

Keywords: Limit order book, volatility, electronic order-driven markets, state-space models, price formation, market microstructure

JEL Classification: G1

Accepted Paper Series