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RFS Advance Access published online on August 31, 2005
Review of Financial Studies, 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
Received October 15, 2004

Article

Limit Order Book as a Market for Liquidity1

Thierry Foucault 1, Ohad Kadan 2, and Eugene Kandel 3*
1 HEC School of Management, Paris and CEPR
2 John M. Olin School of Business, Washington University in St. Louis
3 School of Business Administration, and Department of Economics, Hebrew University, Jerusalem, Israel and CEPR

* To whom correspondence should be addressed.
Eugene Kandel, E-mail: mskandel{at}mscc.huji.ac.il


  Abstract

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.

We thank Bruno Biais, David Easley, Larry Glosten, Larry Harris, Joel Hasbrouck, Frank de Jong, Pete Kyle, Leslie Marx, Narayan Naik, Maureen O’Hara (the editor), Christine Parlour, Patrik Sandas, Duane Seppi, Ilya Strebulaev, Isabel Tkach, Avi Wohl, and two anonymous referees for very helpful comments and suggestions. Comments by seminar participants at Amsterdam, BGU, Bar Ilan, CREST, Emory, Hebrew, Illinois, Insead, LBS, Stockholm, Tel Aviv, Thema, Toulouse, Wharton, and by participants at the Western Finance Association 2001 meeting, the CEPR 2001 Symposium at Gerzensee, and the RFS 2002 Imperfect Markets Conference have been very helpful as well. The authors thank the J. Nachmias Fund, and The Kruger Center at Hebrew University for financial support. Thierry Foucault is also a .liated with GREGHEC. He thanks la Fondation HEC for additional financial support. Finally, we are grateful to Michael Borns for expert editorial assistance.
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