Reduced form modeling of limit order markets

Pekka Malo and Teemu Pennanen

Quantitative Finance, 2012, vol. 12, issue 7, 1025-1036

Abstract: This paper proposes a parametric approach for stochastic modeling of limit order markets. The models are obtained by augmenting classical perfectly liquid market models with a few additional risk factors that describe liquidity properties of the order book. The resulting models are easy to calibrate and to analyse using standard techniques for multivariate stochastic processes. Despite their simplicity, the models are able to capture several properties that have been found in microstructural analysis of limit order markets. Calibration of a continuous-time three-factor model to Copenhagen Stock Exchange data exhibits, for example, mean reversion in liquidity as well as the so-called crowding out effect, which influences subsequent mid-price moves. Our dynamic models are also well suited for analysing market resilience after liquidity shocks.

Date: 2012
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DOI: 10.1080/14697688.2011.589402

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