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Liquidity supply and adverse selection in a pure limit order book market

In: High Frequency Financial Econometrics

Author

Listed:
  • Stefan Frey

    (University of Tübingen)

  • Joachim Grammig

    (University of Tübingen)

Abstract

This paper analyzes adverse selection costs and liquidity supply in a pure open limit order book market. We relax assumptions of the Glosten/Såndas modeling framework regarding marginal zero profit order book equilibrium and the parametric market order size distribution. We show that using average zero profit conditions considerably increases the empirical performance while a nonparametric specification for market order size combined with marginal zero profit conditions does not. A cross sectional analysis corroborates the finding that adverse selection costs are more severe for smaller capitalized stocks. We also find additional support for one of the central hypothesis put forth by the theory of limit order book markets, which states that liquidity supply and adverse selection costs are inversely related. Furthermore, adverse selection cost estimates based on our structural model and those obtained using popular model-free methods are strongly correlated. This indicates the robustness of the theory-based approach.

Suggested Citation

  • Stefan Frey & Joachim Grammig, 2008. "Liquidity supply and adverse selection in a pure limit order book market," Studies in Empirical Economics, in: Luc Bauwens & Winfried Pohlmeier & David Veredas (ed.), High Frequency Financial Econometrics, pages 83-109, Springer.
    • Handle: RePEc:spr:stecpp:978-3-7908-1992-2_5
    DOI: 10.1007/978-3-7908-1992-2_5
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    Cited by:

    1. Fabien Guilbaud & Huyen Pham, 2011. "Optimal High Frequency Trading with limit and market orders," Working Papers hal-00603385, HAL.
    2. Fabien Guilbaud & Huyen Pham, 2011. "Optimal High Frequency Trading with limit and market orders," Papers 1106.5040, arXiv.org.

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