Equilibrium in a Dynamic Limit Order Market

40 Pages Posted: 16 Jun 2003

See all articles by Ronald L. Goettler

Ronald L. Goettler

University of Rochester - Simon School of Business

Christine A. Parlour

University of California, Berkeley - Finance Group

Uday Rajan

Stephen M. Ross School of Business, University of Michigan

Date Written: May 20, 2003

Abstract

We model a dynamic limit order market as a stochastic sequential game. Since the model is analytically intractable, we provide an algorithm based on Pakes and McGuire (2001) to find a stationary Markov-perfect equilibrium. Given the stationary equilibrium, we generate artificial time series and perform comparative dynamics. We demonstrate that the order flow displays persistence. As we know the data generating process, we can compare transaction prices to the true value of the asset, as well as explicitly determine the welfare gains accruing to investors. Due to the endogeneity of order flow, the midpoint of the quoted prices is not a good proxy for the true value. Further, transaction costs paid by market order submitters are negative on average. The effective spread is negatively correlated with true transaction costs, and largely uncorrelated with changes in investor surplus. As a policy experiment, we consider the effect of a change in tick size, and find that it has a very small positive impact on investor surplus.

Keywords: Limit order markets, computational

JEL Classification: G2, C6

Suggested Citation

Goettler, Ronald L. and Parlour, Christine A. and Rajan, Uday, Equilibrium in a Dynamic Limit Order Market (May 20, 2003). EFA 2003 Annual Conference Paper No. 493. Available at SSRN: https://ssrn.com/abstract=410021 or http://dx.doi.org/10.2139/ssrn.410021

Ronald L. Goettler

University of Rochester - Simon School of Business ( email )

Rochester, NY 14627
United States

Christine A. Parlour (Contact Author)

University of California, Berkeley - Finance Group ( email )

Haas School of Business
545 Student Services Building
Berkeley, CA 94720
United States
510-643-9391 (Phone)

Uday Rajan

Stephen M. Ross School of Business, University of Michigan ( email )

701 Tappan Street
Ann Arbor, MI 48109
United States
734-764-2310 (Phone)

HOME PAGE: http://webuser.bus.umich.edu/urajan

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