Working Paper: CEPR ID: DP3676
Authors: Burton Hollifield; Robert A. Miller; Patrik Sands; Joshua Slive
Abstract: We model a trader?s decision to supply liquidity by submitting limit orders or demand liquidity by submitting market orders in a limit order market. The best quotes and the execution probabilities and picking off risks of limit orders determine the price of immediacy. The price of immediacy and the trader?s willingness to pay for immediacy determine the trader?s optimal order submission, with the trader?s willingness to pay for immediacy depending on the trader?s valuation for the stock. We estimate the execution probabilities and the picking off risks using a sample from the Vancouver Stock Exchange to compute the price of immediacy. The price of immediacy changes with market conditions ? a trader?s optimal order submission changes with market conditions. We combine the price of immediacy with the actual order submissions to estimate the unobserved arrival rates of traders and the distribution of the traders? valuations. High realized stock volatility increases the arrival rate of traders and increases the number of value traders arriving ? liquidity supply is more competitive after periods of high volatility. An increase in the spread decreases the arrival rate of traders and decreases the number of value traders arriving ? liquidity supply is less competitive when the spread widens.
Keywords: discrete choice; high frequency data; limit orders; liquidity; market orders
JEL Codes: C25; C41; G14; G15
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| execution probabilities and picking off risks (G11) | price of immediacy (D41) |
| price of immediacy (D41) | optimal order submission (C69) |
| spread (Y60) | arrival rate of traders (F16) |
| stock volatility (G17) | arrival rate of traders (F16) |
| stock volatility (G17) | number of value traders arriving in the market (D46) |
| spread (Y60) | number of value traders (D46) |