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Order Flow Composition and Trading Costs in a Dynamic Limit Order Market

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  • Thierry Foucault

    (GREGH - Groupement de Recherche et d'Etudes en Gestion à HEC - HEC Paris - Ecole des Hautes Etudes Commerciales - CNRS - Centre National de la Recherche Scientifique)

Abstract

This paper provides a game theoretic model of price formation and order placement decisions in a dynamic limit order market. Investors can choose to post limit orders or to submit market orders. Limit orders result in better execution prices but face a risk of non-execution and a winner's curse problem. The execution probability of a limit order trader is endogenous and depends on the order placement decisions of the other traders. Solving for the equilibrium of this dynamic game, closed form solutions for the order placement strategies are obtained. Thus, testable implications for the cross-sectional behaviour of the mix between market and limit orders and trading costs in limit order markets are derived. It is also shown that the winner's curse problem has a negative impact on the allocative efficiency of these markets.

Suggested Citation

  • Thierry Foucault, 2011. "Order Flow Composition and Trading Costs in a Dynamic Limit Order Market," Working Papers hal-00601598, HAL.
    • Handle: RePEc:hal:wpaper:hal-00601598
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    Keywords

    bid and ask prices; limit and market orders; limit order markets; market microstructure; order flow composition;
    All these keywords.

    JEL classification:

    • C72 - Mathematical and Quantitative Methods - - Game Theory and Bargaining Theory - - - Noncooperative Games
    • D44 - Microeconomics - - Market Structure, Pricing, and Design - - - Auctions
    • G19 - Financial Economics - - General Financial Markets - - - Other

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