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Arbitrage-free Limit Order Books and the Pricing of Order Flow Risk

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  • Bruce Lehmann

Abstract

This paper builds on the landmark contribution of Glosten (1994) by treating the determination of limit order supply schedules as an exercise in asset pricing theory with the possible sizes of incoming market orders as the value-relevant states of nature, yielding an analogue of the Fundamental Theorem of Asset Pricing. State prices and price impact prove to be proportional to the slope of the book and simple nonparametric and semiparametric models for limit order book dynamics arise when the price of order flow risk is constant over time, providing a comprehensive and coherent framework for organizing limit order book data.

Suggested Citation

  • Bruce Lehmann, 2008. "Arbitrage-free Limit Order Books and the Pricing of Order Flow Risk," NBER Working Papers 13848, National Bureau of Economic Research, Inc.
  • Handle: RePEc:nbr:nberwo:13848
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    References listed on IDEAS

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    Cited by:

    1. Ole E. Barndorff-Nielsen & David G. Pollard & Neil Shephard, 2012. "Integer-valued Lévy processes and low latency financial econometrics," Quantitative Finance, Taylor & Francis Journals, vol. 12(4), pages 587-605, January.
    2. Rossen Trendafilov & Erick W Rengifo, 2012. "Regime Identification in Limit Order Books," Fordham Economics Discussion Paper Series dp2012_04, Fordham University, Department of Economics.

    More about this item

    JEL classification:

    • G1 - Financial Economics - - General Financial Markets
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing

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