When are Limit Orders Linear?

23 Pages Posted: 25 Jan 2011  

André Levy

Australian Prudential Regulation Authority

Peter L. Swan

University of New South Wales (UNSW Australia); Financial Research Network (FIRN)

Date Written: January 20, 2011

Abstract

We show how core assumptions on risk preferences and risk distributions in the microstructure literature shape its conclusions for investment demand curves in equilibrium. In particular, we show that the assumptions of CARA preferences and joint normality of exogenous risk factors and payoffs imply equilibrium demand curves to be linear and thus unique. Our setting is strategic trading under both information symmetry and asymmetry. The literature thus far either accepts linearity by ad hoc assumption or attempts to show it by circular argument. In either case, it fails to connect explicitly demand linearity to core assumptions. This is significant against mounting evidence showing investment demand curves to be nonlinear in reality. The results in this paper thus show rigorously that linear equilibriums in the huge existing literature are in fact unique and that additional apparently ad hoc assumptions such as ‘symmetry’ that are often made are in fact redundant. They thus impose no added restrictions. Ultimately, we point to what models’ assumptions need to change to better represent and explain observed behavior.

Keywords: market microstructure, uniqueness, market power, Kyle model, market impact

JEL Classification: C62, D82, G14

Suggested Citation

Levy, André and Swan, Peter L., When are Limit Orders Linear? (January 20, 2011). Available at SSRN: https://ssrn.com/abstract=1746524 or http://dx.doi.org/10.2139/ssrn.1746524

André Levy

Australian Prudential Regulation Authority ( email )

400 George Street
Sydney, NSW 2000
Australia
61292103219 (Phone)

HOME PAGE: http://www.apra.gov.au

Peter Lawrence Swan (Contact Author)

University of New South Wales (UNSW Australia) ( email )

School of Banking and Finance
UNSW Business School
Sydney NSW, NSW 2052
Australia
+61 2 9385 5871 (Phone)
+61 2 9385 6347 (Fax)

HOME PAGE: http://https://www.business.unsw.edu.au/our-people/peterswan

Financial Research Network (FIRN)

C/- University of Queensland Business School
St Lucia, 4071 Brisbane
Queensland
Australia

HOME PAGE: http://www.firn.org.au

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