The limit order book is a device for storing demand and effecting trades that is the primary mechanism for price formation in most modern financial markets. We study the limit order book under a random process model of order flow, using simulations and an analytic treatment based on a master equation. We make testable predictions of the price diffusion rate, the depth of stored demand vs. price, the bid-ask spread, and the price impact. Our model provides an explanation for the empirically observed concave form of the price impact function.
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Paper provided by Santa Fe Institute in its series Working Papers with number
02-01-001.
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