Equilibrium in a dynamic limit order market

Ronald L Goettler, Christine A Parlour and Uday Rajan

No 2003-E23, GSIA Working Papers from Carnegie Mellon University, Tepper School of Business

Abstract: We provide an algorithm for solving for equilibrium in a dynamic limit order market. Our model relaxes many of the restrictive assumptions in the prior literature, leading to a more realistic framework for policy experiments on market design. We formulate a limit order market as a stochastic sequential game and use a simulation technique based on Pakes and McGuire (2001) to find a stationary equilibrium. Given the stationary equilibrium, we generate artificial time series and perform comparative dynamics. We explicitly determine investor welfare in our numerical solution. We find that the effective spread is {\it negatively} correlated with transactions costs and uncorrelated with welfare. As one policy experiment, we evaluate the effect of changing tick size.

Date: 2003-10
New Economics Papers: this item is included in nep-cmp, nep-fin and nep-fmk
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