An Empirical Investigation of the Option Value of the Limit Order Book on the Australian Stock Exchange

Abstract

There have been a number of investigations of the individual characteristics of the limit order book (Lee, Mucklow, and Ready, 1993; Harris, 1994; Bruno, Hillion, and Spatt, 1995). Lee, Mucklow, and Ready report that wide spreads are accompanied by low depths and that spreads widen and depths fall in response to higher volume. Harris (1994) however suggests a positive relationship between spreads and depth during normal trading periods. Based on the approach of Copeland and Galai (1983) and Brenner and Subrahmanyam (1988), we calculate the option value of the limit order book for four snapshots each day (11:00, 12:00, 14:30, and 15:58) for thirty firms listed on the Australian Stock Exchange. This approach enables us to consider the spread and depth of the limit order book simultaneously. We find that the option value of the limit order book is stable from day to day with changes in value due to changes in spreads offsetting those due to changes in depth. We find that the option value of the limit order book is lowest at 11:00 when the relatively higher bid/offer sizes do not offset the wider spreads. The option value of the limit order book increases throughout the trading day and almost 80% of the option value of the limit order book is concentrated at the best bid and ask.

JEL Classification: G13