12.

Models of limit-order markets

12.1 Cohen, Maier, Schwartz, and Whitcomb (1981)
- Traders maximize their wealth that consists of cash and a risky asset.
- Traders trade only at a set of fixed points of time.
- Trading costs include a fee for submitting a limit order and a another fee
paid in case an order is filled.
- Trading is symmetric on both sides of the market.
- Price follows random walk with shocks summed up between trading
according to the compound Poisson process
N ()

ln St() = ln St + Z
i 1
i

- time between trading points, price shocks

Zi are IID with zero mean
N() is a Poisson process with arrival rate .
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 12. Models of limit-order markets

12.1 CMSW (continued)

Traders choice:
- not to trade
- market buy
- bid at a price lower than current ask

Probability to fill a limit order is always less than unity

First passage time (FPT): S(t=0) = S0. FPT for shock s is the time t of the
first instance when S(t) <= S0 - s.

fFPT(s, t) = ~ t-3/2

Expected time is infinite.

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 12. Models of limit-order markets

12.1 CMSW (continued 2)

Dynamic programming problem of maximizing traders wealth.

In the CMSW model, the bid/ask spread is determined with transaction costs.
If the spread is wide, traders submit new limit orders that have lower spread
but still have lower loss than market orders. When the spread narrows to the
extent that fees for submitting limit orders negate their gain, traders may want
to submit market orders (gravitational pull). Order matching widens the
spread as market orders wipe out top of the book. Ultimately the spread
attains some equilibrium value.

Market thickness is defined with order arrival rate.

The spread increases as the market becomes thinner.

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 12. Models of limit-order markets

12.2 The Parlour model (1998)

- Risk-neutral traders perceive asset value as v(t); v fundamental value;
(t) randomly distributed within [ , ] .
- Exogenous bid (B) and ask (A) prices + active LOB with nA(t) and nB(t)
- One trader at a time trades one unit of asset at times t = 1, ..., T.
- Buy or Sell with probability 0.5.
- Buyer: If v(t) > A: nA(t+1) = nA(t) 1; else: nB(t+1) = nB(t) + 1.
- Seller: If v(t) < B: nB(t+1) = nB(t) 1; else: nA(t+1) = nA(t) + 1.

Optimal solution depends on the history. Hence backward recursion.

The last trader (T) does not submit limit orders. Hence the change in active
LOB is known at time T. Then the action of trader T-1 is determined, etc.

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 12. Models of limit-order markets

12.2 The Parlour model (continued)

The outcome coincides with empirical findings:

Market orders are more likely submitted after market orders on the same
side of the market. Indeed, one may expect that a buy order diminishes
liquidity on the ask side, which motivates a seller to submit a limit ask order.

Buyer (seller) is more likely to submit a market order in case of a thick LOB
on the bid (ask) side. On the other hand, a thick LOB on the offer (bid) side
motivates a buyer (seller) to submit a limit order.

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 12. Models of limit-order markets

12.3 The Foucault model (1999)

Winners curse: the highest bid and lowest offer picked off by market
orders may be mispriced.

- One trader at a time trades one unit of asset at times t = 1, ..., T.

- Trading can stop at any time with Pr = 1 -
- Asset value follows random walk: v(t) = v(t-1) + (t); (t) = with Pr = 0.5.
- Traders estimate of asset value: R(t) = v(t) + y(t); y(t) = L with Pr = 0.5.
- Trader may submit buy or sell, market or limit order.
- Limit orders live one period, then they are cancelled.
- If bid side is empty, B(t) = -; if the ask side is empty, A(t) = , and trader
posts orders on both sides of the market.

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 12. Models of limit-order markets
12.3 The Foucault model (continued)

12.3.1 Equilibrium with zero volatility

= 0 (no winners curse):
S* = 2L(1 0.5)/(1 + 0.5)

12.3.2 Volatility effect:

S* = + 2(2L )/(2 + ) when < 4L/(4 + )

S* = 2 + 8L/(4 + ) when 4L/(4 + )

- 1st term (winners curse): higher motivates to submit limit orders.

- 2nd term (costs): higher decreases the spread.

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 12. Models of limit-order markets
12.4 Summary
Thinner LOB has a wider spread.
Market orders are more likely submitted after market orders on the same
side of LOB.
Buyer (seller) is more likely to submit market order in case of thick LOB on
the bid (ask) side.
Buyer (seller) is more likely to submit limit order in case of thick LOB on the
ask (bid) side.
The spread increases with volatility.
Winners curse occurs when a limit order filled due to price volatility turns out
to be mispriced.
Patient traders submit less aggressive limit orders, which increases the
spread.
Limit orders can cluster outside the market, generating a hump-shaped LOB.