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No 728:
Limit order book as a market for liquidity

Thierry FOUCAULT, Ohad KADAN and Eugene KANDEL

Abstract: We develop a dynamic model of an order-driven market populated by discretionary liquidity traders. These traders must trade, yet can choose the type of order and are fully strategic in their decision. Traders differ by their impatience: less patient traders demand liquidity, more patient traders provide it. Three equilibrium types are obtained - the type is determined by three parameters: the degree of impatience of the patient traders, which we interpret as the cost of execution delay in providing liquidity; their proportion in the population, which is the cost of the minimal price improvement. Despite its simplicity, the model generates a rich set empirical predictions on the relation between market parameters, time to execution, and spreads. We argue that the economic intuition of this model is robust, thus its main results will remain in more general models.

Keywords: limit and market orders; time-to-execution; market quality; (follow links to similar papers)

JEL-Codes: C51; G10; G14; (follow links to similar papers)

54 pages, July 10, 2001

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