Quote Setting and Price Formation in an Order Driven Market

Abstract

The paper models the process of quote setting and price formation in a non-intermediated order driven market where trading is driven by (1) differences in valuation among investors and (2) the arrival of new information. We show that a positive spread exists in an order driven market even in the absence of intermediaries. We further show that the bid and ask prices are functions of the differences in valuation among investors and adverse selection. Both GMM estimation of the model parameters using transaction data for the SBF Bourse de Paris CAC40 stocks, and empirical evidence on spread behavior as the relative proportion of buyers and sellers in the market changes, provide strong support for our model. Our analysis yields insights into the determinants of the bid and ask prices and of the spread in the absence of intermediaries.

JEL Classification: D40, G12