Limit and Market Orders with Optimizing Traders
Posted: 20 Dec 1998
Date Written: July 1994
We study a microstructure model with non-strategic liquidity traders, Rock (1990) style value traders and possibly a strategic trader with private information. Traders optimize using market orders and schedules of price-contingent limit orders. Market depth in the different order types is endogenous, depending on the liquidity traders' optimization problem. We characterize Nash (or Bayesian Nash) equilibria of this market for two cases. The first has no informed trader, but exogenous arrival of value information. The second includes an informed trader resulting in both endogenous information revelation (via order flows) and in a "winner's curse" problem in limit order execution. Our results include (a) a random limit order book which together with market orders is generated by an exact linear factor model, (b) a relatively modest role for value traders given even moderate brokerage costs, (c) thinner limit order books in volatile than in "flat" markets and (d) a sufficient statistic for multiple order types used for Bayesian updating in the presence of an informed trader.
JEL Classification: G14, G24
Suggested Citation: Suggested Citation