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A Market-Clearing Role for Inefficiency on a Limit Order Book

  • Jeremy Large

    ()

    (All Souls College, University of Oxford)

Using a stochastic sequential game in ergodic equilibrium, this paper models limit order book trading dynamics. It deduces investor surplus and some agents' strategies from depth's stationarity, while bypassing altogether agents' intricate forecasting problems. Market inefficiency adjusts to induce equal supply and demand for liquidity over time. Consequently, at a given bid-ask spread surplus per investor is invariant to faster, more regular or more sophisticated trading, or modified queuing rules: apparent improvements are offset as inefficiency adjusts back to market-clearing levels. Moreover, investor surplus decreases with the spread. In the model, price discreteness fixes the spread at the tick size. Narrowing the tick is beneficial, but may be resisted by sell-side traders.

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File URL: http://www.nuffield.ox.ac.uk/economics/papers/2006/w8/TickWelfareJuly06.pdf
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Paper provided by Economics Group, Nuffield College, University of Oxford in its series Economics Papers with number 2006-W08.

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Length: 40 pages
Date of creation: 14 Jul 2006
Date of revision:
Handle: RePEc:nuf:econwp:0608
Contact details of provider: Web page: http://www.nuff.ox.ac.uk/economics/

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  19. Lee, Charles M C & Mucklow, Belinda & Ready, Mark J, 1993. "Spreads, Depths, and the Impact of Earnings Information: An Intraday Analysis," Review of Financial Studies, Society for Financial Studies, vol. 6(2), pages 345-74.
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