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Reinforcement learning and rational expectations equilibrium in limit order markets

Author

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  • Zhou, Xuan
  • Lin, Shen
  • He, Xue-Zhong

Abstract

This paper shows that simple payoff-based reinforcement learning can help to achieve rational expectations equilibrium in limit order markets. In equilibrium, speculators mainly supply liquidity, while liquidity consumption increases in the private values of no-speculators with intrinsic motives for trade. Driven by information acquisition of the non-speculators, liquidity consumption is hump-shaped in fundamental volatility for the speculators but U-shaped for the non-speculators. In contrast, liquidity supply decreases in fundamental volatility for the speculators but is hump-shaped for the non-speculators. Unlike the informed traders who trade on asset fundamentals, the uninformed traders trade more on order book and trading information.

Suggested Citation

  • Zhou, Xuan & Lin, Shen & He, Xue-Zhong, 2025. "Reinforcement learning and rational expectations equilibrium in limit order markets," Journal of Economic Dynamics and Control, Elsevier, vol. 172(C).
    • Handle: RePEc:eee:dyncon:v:172:y:2025:i:c:s0165188924001830
    DOI: 10.1016/j.jedc.2024.104991
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    More about this item

    Keywords

    Limit order market; Reinforcement learning; Rational expectations; Liquidity supply and consumption;
    All these keywords.

    JEL classification:

    • G14 - Financial Economics - - General Financial Markets - - - Information and Market Efficiency; Event Studies; Insider Trading
    • C63 - Mathematical and Quantitative Methods - - Mathematical Methods; Programming Models; Mathematical and Simulation Modeling - - - Computational Techniques
    • D82 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Asymmetric and Private Information; Mechanism Design
    • D83 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Search; Learning; Information and Knowledge; Communication; Belief; Unawareness

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