Strategy Analysis of Chanel

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A Dynamic Model of the Limit Order Book

By Ioanid Rosu1 ¸

This paper presents a model of an order-driven market where fully strategic, symmetrically informed liquidity traders dynamically choose between limit and market orders, trading off execution price and waiting costs. In equilibrium the bid and ask prices depend only on the numbers of buy and sell orders in the book. The model has a number of empirical predictions: (i) higher trading activity and higher trading competition cause smaller spreads and lower price impact; (ii) market orders lead to a temporary price impact larger than the permanent price impact, therefore to price overshooting; (iii) buy and sell orders can cluster away from the bid-ask spread, generating a humpshaped order book; (iv) bid and ask prices display a comovement effect: after, e.g., a sell market order moves the bid price down, the ask price also falls, by a smaller amount, so the bid-ask spread widens; (v) when the order book is full, traders may submit quick, or fleeting, limit orders. (JEL C7, D4, G1) Keywords: Liquidity, waiting costs, price impact, order driven market, price overshooting, fleeting orders.



This article presents a model of price formation in an order-driven market, where agents trade via a limit order book.2 Compared with a quote-driven market in which market makers provide liquidity by setting bid and ask quotes, in an order-driven market there are no designated market makers. Instead, liquidity is offered in a decentralized way, with anonymous traders who place orders in the limit order book, and wait until the orders get executed. Nowadays, more than half of the world’s stock exchanges are order driven, with a limit order book at the

Date: December 10, 2008. Booth School of Business, University of Chicago, 5807 South Woodlawn Avenue, Chicago, IL 60637; telephone: 773-834-1826; fax: 773-834-0944; e-mail: The author thanks Rob Battalio, Shane Corwin, Thierry Foucault,...