A Continuous and Efficient Fundamental Price on the Discrete Order Book Grid

24 Pages Posted: 16 Nov 2016

See all articles by Julius Bonart

Julius Bonart

Imperial College London, CFM-Imperial Institute of Quantitative Finance; University College London - Financial Computing and Analytics Group, Department of Computer Science

Fabrizio Lillo

Università di Bologna

Date Written: November 15, 2016

Abstract

This paper develops a model of liquidity provision in financial markets by adapting the Madhavan, Richardson, and Roomans (1997) price formation model to realistic order books with quote discretization and liquidity rebates. We postulate that liquidity providers observe a fundamental price which is continuous, efficient, and can assume values outside the interval spanned by the best quotes. We confirm the predictions of our price formation model with extensive empirical tests on large high-frequency datasets of 100 liquid Nasdaq stocks. Finally we use the model to propose an estimator of the fundamental price based on the rebate adjusted volume imbalance at the best quotes and we empirically show that it outperforms other simpler estimators.

Keywords: price formation, liquidity provision, tick size, market microstructure

JEL Classification: G10

Suggested Citation

Bonart, Julius and Lillo, Fabrizio, A Continuous and Efficient Fundamental Price on the Discrete Order Book Grid (November 15, 2016). Available at SSRN: https://ssrn.com/abstract=2817279 or http://dx.doi.org/10.2139/ssrn.2817279

Julius Bonart (Contact Author)

Imperial College London, CFM-Imperial Institute of Quantitative Finance ( email )

South Kensington Campus
Imperial College
LONDON, SW7 2AZ
United Kingdom

University College London - Financial Computing and Analytics Group, Department of Computer Science ( email )

Gower Street
London, WC1E 6BT
United Kingdom

Fabrizio Lillo

Università di Bologna ( email )

Via Zamboni, 33
Bologna, 40126
Italy

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