Informed Traders and Limit Order Markets

44 Pages Posted: 29 Sep 2006 Last revised: 12 Feb 2008

See all articles by Ronald L. Goettler

Ronald L. Goettler

University of Rochester - Simon School of Business

Christine A. Parlour

University of California, Berkeley - Finance Group

Uday Rajan

Stephen M. Ross School of Business, University of Michigan

Date Written: January 12, 2008

Abstract

We consider informed traders in a limit order market for a single asset. The asset has a common value; in addition, each trader has a private value for it. Traders randomly arrive at the market, after choosing whether to purchase information about the common value. They may either post prices or accept posted prices. If a trader's order has not executed, he randomly reenters the market, and may change his previous order. The model is thus a dynamic stochastic game with asymmetric information. We numerically solve for equilibrium in the model, and simulate market outcomes. Agents' incentives to acquire information and their subsequent equilibrium trading behavior changes systematically with the underlying volatility of the asset. Agents with no intrinsic benefit from trade have the highest value for information and also tend to supply liquidity. However, these agents reduce their liquidity provision when the asset volatility is high. In equilibrium, the limit order market acts as a "volatility multiplier'': prices are more volatile than the fundamental value of the asset. This effect increases when the fundamental volatility of the asset is higher or when there is asymmetric information across traders, due to a change in the composition of trader types that choose to provide liquidity. Further, changes in the microstructure noise are negatively correlated with changes in the estimated fundamental value, implying that asset betas estimated from high-frequency data will be incorrect.

Keywords: limit order market, adverse selection, microstructure noise, asset pricing implications

JEL Classification: C73, D82, G12

Suggested Citation

Goettler, Ronald L. and Parlour, Christine A. and Rajan, Uday, Informed Traders and Limit Order Markets (January 12, 2008). Available at SSRN: https://ssrn.com/abstract=933358 or http://dx.doi.org/10.2139/ssrn.933358

Ronald L. Goettler (Contact Author)

University of Rochester - Simon School of Business ( email )

Rochester, NY 14627
United States

Christine A. Parlour

University of California, Berkeley - Finance Group ( email )

Haas School of Business
545 Student Services Building
Berkeley, CA 94720
United States
510-643-9391 (Phone)

Uday Rajan

Stephen M. Ross School of Business, University of Michigan ( email )

701 Tappan Street
Ann Arbor, MI 48109
United States
734-764-2310 (Phone)

HOME PAGE: http://webuser.bus.umich.edu/urajan

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