Learning about Latent Dynamic Trading Demand
53 Pages Posted: 28 May 2021 Last revised: 6 Aug 2021
Date Written: May 27, 2021
This paper presents an equilibrium model of dynamic trading, learning, and pricing by strategic investors with trading targets and price impact. Since trading targets are private, rebalancers and liquidity providers filter the child order flow over time to estimate the latent underlying parent trading demand imbalance and its expected impact on subsequent price pressure dynamics. We prove existence of the equilibrium and solve for equilibrium trading strategies and prices in terms of the solution to a system of coupled ODEs. We show that trading strategies are combinations of trading towards investor targets, liquidity provision for other investors’ demands, and front-running based on learning about latent underlying trading demand imbalances and future price pressure.
Keywords: Order-splitting, optimal order execution, subgame perfect Nash equilibrium, dynamic learning, trading targets, front-running
JEL Classification: G11, G12
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