Learning about Latent Dynamic Trading Demand

53 Pages Posted: 28 May 2021 Last revised: 18 Oct 2021

See all articles by Xiao Chen

Xiao Chen

Rutgers, The State University of New Jersey

Jin Hyuk Choi

Ulsan National Institute of Science and Technology (UNIST)

Kasper Larsen

Rutgers, The State University of New Jersey

Duane J. Seppi

Carnegie Mellon University - David A. Tepper School of Business

Date Written: May 27, 2021

Abstract

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

Suggested Citation

Chen, Xiao and Choi, Jin Hyuk and Larsen, Kasper and Seppi, Duane J., Learning about Latent Dynamic Trading Demand (May 27, 2021). Available at SSRN: https://ssrn.com/abstract=3855056 or http://dx.doi.org/10.2139/ssrn.3855056

Xiao Chen

Rutgers, The State University of New Jersey ( email )

311 North 5th Street
New Brunswick, NJ 08854
United States

Jin Hyuk Choi

Ulsan National Institute of Science and Technology (UNIST) ( email )

gil 50
Ulsan, 689-798
Korea, Republic of (South Korea)

Kasper Larsen (Contact Author)

Rutgers, The State University of New Jersey ( email )

311 North 5th Street
New Brunswick, NJ 08854
United States

Duane J. Seppi

Carnegie Mellon University - David A. Tepper School of Business ( email )

5000 Forbes Avenue
Pittsburgh, PA 15213-3890
United States
412-268-2298 (Phone)
412-268-8896 (Fax)

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