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Reduced form modeling of limit order markets

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  • Pekka Malo
  • Teemu Pennanen

Abstract

This paper proposes a parametric approach for stochastic modeling of limit order markets. The models are obtained by augmenting classical perfectly liquid market models with a few additional risk factors that describe liquidity properties of the order book. The resulting models are easy to calibrate and to analyse using standard techniques for multivariate stochastic processes. Despite their simplicity, the models are able to capture several properties that have been found in microstructural analysis of limit order markets. Calibration of a continuous-time three-factor model to Copenhagen Stock Exchange data exhibits, for example, mean reversion in liquidity as well as the so-called crowding out effect, which influences subsequent mid-price moves. Our dynamic models are also well suited for analysing market resilience after liquidity shocks.

Suggested Citation

  • Pekka Malo & Teemu Pennanen, 2012. "Reduced form modeling of limit order markets," Quantitative Finance, Taylor & Francis Journals, vol. 12(7), pages 1025-1036, April.
  • Handle: RePEc:taf:quantf:v:12:y:2012:i:7:p:1025-1036
    DOI: 10.1080/14697688.2011.589402
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    File URL: http://hdl.handle.net/10.1080/14697688.2011.589402
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    References listed on IDEAS

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    1. Yuri Kabanov, 2009. "Markets with Transaction Costs. Mathematical Theory," Post-Print hal-00488168, HAL.
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    Cited by:

    1. Teemu Pennanen, 2014. "Optimal investment and contingent claim valuation in illiquid markets," Finance and Stochastics, Springer, vol. 18(4), pages 733-754, October.
    2. repec:eee:ecolet:v:159:y:2017:i:c:p:65-68 is not listed on IDEAS
    3. repec:eee:finlet:v:21:y:2017:i:c:p:264-271 is not listed on IDEAS
    4. Lee, Kyungsub & Seo, Byoung Ki, 2017. "Marked Hawkes process modeling of price dynamics and volatility estimation," Journal of Empirical Finance, Elsevier, vol. 40(C), pages 174-200.

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