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Modeling Electronic FX Brokerage as a Fast Order-Driven Marketunder Heterogeneous Private Values and Information

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Abstract

The paper develops a theoretical framework for studying price formation in brokered foreign exchange markets with very high order arrival frequency (to be followed by an application to real data on Czech koruna transactions in subsequent work). I construct a model of an order-driven market with very volatile motives for trade and a large number of (nearly) simultaneous limit and market order submissions. The model is applicable to very frequently traded securities such as high-grade bonds or FX. Investors have a non-trivial distribution of private values for the traded asset as well as heterogeneous information about the parameters of this distribution across traders. I investigate the properties of the mapping from the histogram of private asset values and private information endowments to the inside bid and ask price. Basic relationships between the limit order book, market sell and market buy order flow distributions, expected market order execution prices and the probabilities of a limit order execution at a given price, all as functions of private information, are derived. Traders are risk neutral as long as the transacted quantities are small, so that the limit and the market order decisions within one trading round do not feed back into private values. I formulate the equations that characterize the best ask and bid prices in this environment, as well as establish a number of properties of the equilibrium order book.

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Bibliographic Info

Paper provided by Charles University Prague, Faculty of Social Sciences, Institute of Economic Studies in its series Working Papers IES with number 2007/16.

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Length: 36 pages
Date of creation: May 2007
Date of revision: May 2007
Handle: RePEc:fau:wpaper:wp2007_16

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Keywords: broker; limit order; market order; market maker; private value; signal;

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  1. Martin D. D. Evans and Richard K. Lyons., 1999. "Order Flow and Exchange Rate Dynamics," Research Program in Finance Working Papers RPF-288, University of California at Berkeley.
  2. Wadim Strielkowski, 2006. "People of the Road: the Role of Ethnic Origin in Migration Decisions. A Study of Slovak Roma Asylum-Seekers in the Czech Republic in 1998-2006," Working Papers IES 2006/32, Charles University Prague, Faculty of Social Sciences, Institute of Economic Studies, revised Dec 2006.
  3. Foucault, Thierry, 1999. "Order flow composition and trading costs in a dynamic limit order market1," Journal of Financial Markets, Elsevier, vol. 2(2), pages 99-134, May.
  4. Glosten, Lawrence R, 1989. "Insider Trading, Liquidity, and the Role of the Monopolist Specialist," The Journal of Business, University of Chicago Press, vol. 62(2), pages 211-35, April.
  5. Handa, Puneet & Schwartz, Robert & Tiwari, Ashish, 2003. "Quote setting and price formation in an order driven market," Journal of Financial Markets, Elsevier, vol. 6(4), pages 461-489, August.
  6. Kyle, Albert S, 1985. "Continuous Auctions and Insider Trading," Econometrica, Econometric Society, vol. 53(6), pages 1315-35, November.
  7. Danielsson, J. & Payne, R., 2002. "Real trading patterns and prices in spot foreign exchange markets," Journal of International Money and Finance, Elsevier, vol. 21(2), pages 203-222, April.
  8. Glosten, Lawrence R, 1994. " Is the Electronic Open Limit Order Book Inevitable?," Journal of Finance, American Finance Association, vol. 49(4), pages 1127-61, September.
  9. Biais, Bruno & Hillion, Pierre & Spatt, Chester, 1995. " An Empirical Analysis of the Limit Order Book and the Order Flow in the Paris Bourse," Journal of Finance, American Finance Association, vol. 50(5), pages 1655-89, December.
  10. Handa, Puneet & Schwartz, Robert A, 1996. " Limit Order Trading," Journal of Finance, American Finance Association, vol. 51(5), pages 1835-61, December.
  11. Kenneth A. Froot & Tarun Ramadorai, 2005. "Currency Returns, Intrinsic Value, and Institutional-Investor Flows," Journal of Finance, American Finance Association, vol. 60(3), pages 1535-1566, 06.
  12. Parlour, Christine A, 1998. "Price Dynamics in Limit Order Markets," Review of Financial Studies, Society for Financial Studies, vol. 11(4), pages 789-816.
  13. ronald l goettler & christine a parlour & uday rajan, 2003. "Equilibrium in a dynamic limit order market," GSIA Working Papers 2003-E23, Carnegie Mellon University, Tepper School of Business.
  14. Alexis Derviz, 2003. "FOREX Microstructure, Invisible Price Determinants,and the Central Bank's Understanding of Exchange Rate Formation," Working Papers 2003/06, Czech National Bank, Research Department.
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