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The optimal strategies of competitive high-frequency traders and effects on market liquidity

Author

Listed:
  • Ge, Hengshun
  • Yang, Haijun
  • Doukas, John A.

Abstract

This paper proposes a theoretical model of the competition among high-frequency traders and its impact on market liquidity. First, the optimal strategies of high-frequency market-makers and corresponding effects are explored. Then two-sided quotes and high-frequency speculators are introduced to enrich our model. Furthermore, we calculate the equilibrium in steady-state and analyze parameters in the equilibrium. The empirical results, consistent with the predictions of our model, show that a lower exchange latency leads to a lower bid-ask spread and the market maker's preference for a two-sided quote. In addition, the speed and information advantages of the market-maker are beneficial to liquidity, while speculators consume liquidity. Furthermore, we employ intra-day data of OMXC20 and three major currency pairs (EUR/USD, USD/JPY, and GBP/USD) in the forex market to verify the predictions of our model.

Suggested Citation

  • Ge, Hengshun & Yang, Haijun & Doukas, John A., 2024. "The optimal strategies of competitive high-frequency traders and effects on market liquidity," International Review of Economics & Finance, Elsevier, vol. 91(C), pages 653-679.
    • Handle: RePEc:eee:reveco:v:91:y:2024:i:c:p:653-679
    DOI: 10.1016/j.iref.2024.01.064
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    More about this item

    Keywords

    High-frequency trading; Optimal strategy; Market liquidity; Bid-ask spread; Forex market;
    All these keywords.

    JEL classification:

    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G14 - Financial Economics - - General Financial Markets - - - Information and Market Efficiency; Event Studies; Insider Trading
    • G15 - Financial Economics - - General Financial Markets - - - International Financial Markets
    • G40 - Financial Economics - - Behavioral Finance - - - General

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