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RFS Advance Access originally published online on August 31, 2005
Review of Financial Studies 2005 18(4):1171-1217; doi:10.1093/rfs/hhi029
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© The Author 2005. Published by Oxford University Press. All rights reserved. For Permissions, please email: journals.permissions@oupjournals.org

Limit Order Book as a Market for Liquidity

Thierry Foucault
HEC School of Management, Paris and CEPR

Ohad Kadan
John M. Olin School of Business, Washington University in St. Louis

Eugene Kandel
School of Business Administration, and Department of Economics, Hebrew University

Address correspondence to Eugene Kandel, Department of Economics, Hebrew University, Mt. Scopus, Jerusalem, Israel, 91905", and CEPR, or e-mail:mskandel{at}mscc.huji.ac.il.

We develop a dynamic model of a limit order market populated by strategic liquidity traders of varying impatience. In equilibrium, patient traders tend to submit limit orders, whereas impatient traders submit market orders. Two variables are the key determinants of the limit order book dynamics in equilibrium: the proportion of patient traders and the order arrival rate. We offer several testable implications for various market quality measures such as spread, trading frequency, market resiliency, and time to execution for limit orders. Finally, we show the effect of imposing a minimal price variation on these measures.


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