Reinforcement Learning and Rational Expectations Equilibrium in Limit Order Markets

Abstract

This paper shows that simple payoff-based reinforcement learning can help to achieve rational expectations equilibrium in limit order markets. In equilibrium, speculators mainly supply liquidity, while liquidity consumption increases in the private values of no-speculators with intrinsic motives for trade. Driven by information acquisition of the non-speculators, liquidity consumption is hump-shaped in fundamental volatility for the speculators but U-shaped for the non-speculators. In contrast, liquidity supply decreases in fundamental volatility for the speculators but is hump-shaped for the non-speculators. Unlike the informed traders who trade on asset fundamentals, the uninformed traders trade more on order book and trading information.

Keywords: Limit order market, reinforcement learning, rational expectations, liquidity supply and consumption

JEL Classification: G14, C63, D82, D83