The effect of supply and demand in a dynamic limit order based financial market
This study focuses on the role of the order book on price formation in financial markets. It employs a computational model inspired by Gode and Sunder's Zero Intelligence Framework to investigate the effect of the supply and demand schedules of traders in this context. From this model insight is gained into the relationship between the state of the order book and the state of the market. It is shown that a relationship exists between the composition of the order book, actual trade prices and the equilibrium price of the market. In so doing the extent to which future price movements and market behaviour can be determined from the current market and order book state, i.e. the spread and slopes of the order book, is also demonstrated. The numbers of traders within the market and the rate at which they enter and leave is shown to have a significant effect on the observed market behaviour, in particular the density of the order book and as a consequence the volatility of the market are dependant on this factor.
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