A Behavioural Model of Investor Sentiment in Limit Order Markets

Carl Chiarella, Xuezhong (Tony) He (), Lei Shi () and Lijian Wei ()

No 342, Research Paper Series from Quantitative Finance Research Centre, University of Technology, Sydney

Abstract: This paper examines the effect of behavioral sentiment in a limit order market when agents are risk averse and arrive in the market with different time horizons. The order submission rules with respect to order type and size are determined by maximizing the expected utility of agents with heterogeneous beliefs on the fundamental price and investment horizon. We show that behavioral sentiment has a double-edge impact on market quality: it improves market liquidity by reducing bid-ask spread and market volatility but increasing trading volume; however, it reduces pricing efficiency by increasing the price deviation from the fundamental value. Consistent with empirical observations, the model is able to replicate a number of stylized facts and limit book phenomena, including insignificant autocorrelations in returns, but significant and decaying autocorrelations in the absolute returns, the bid-ask spread and the trading volume, hump shaped order books, a concave relationship between trade imbalance and average mid-price returns, and event clustering in order submissions. More important, the behavioral sentiment plays a very important role in explaining the positive autocorrelation in trading volume and also event clustering.

Pages: 22 pages
Date: 2014-02-01
New Economics Papers: this item is included in nep-mst
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Citations: View citations in EconPapers (2)

Published as: Chiarella, C., He, X., Shi, L. and Wei, L., 2017, "A Behavioural Model of Investor Sentiment in Limit Order Markets", Quantitative Finance, 17(1), 71-86.

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Related works:
Journal Article: A behavioural model of investor sentiment in limit order markets (2017)
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