Liquidity and Information in Order Driven Markets

Abstract

This paper proposes a dynamic model of an order driven market with asymmetric information and stochastic fundamental value. In equilibrium, informed traders submit market orders only when they see a fundamental value far from the public price; otherwise, they submit limit orders. Under fairly general assumptions, the price impact of a market order is about four times larger than the price impact of a limit order; this ratio is independent of the parameters of the model. The price impact of a market order does not depend on the fraction of informed traders. Surprisingly, a higher fraction of informed traders generates smaller bid-ask spreads. The ratio of intra-day price volatility to the average spread can be used to estimate the probability of informed trading.