This paper develops a model of liquidity provision in financial markets by adapting the Madhavan et al. (1997) price formation model to realistic order books with quote discretization and liquidity rebates. We postulate that liquidity providers observe a fundamental price which is continuous, efficient, and can assume values outside the interval spanned by the best quotes. We confirm the predictions of our price formation model with extensive empirical tests on large high-frequency datasets of 100 liquid Nasdaq stocks. Finally we use the model to propose an estimator of the fundamental price based on the rebate adjusted volume imbalance at the best quotes and we empirically show that it outperforms other simpler estimators.

A continuous and efficient fundamental price on the discrete order book grid

Lillo, Fabrizio
2018-01-01

Abstract

This paper develops a model of liquidity provision in financial markets by adapting the Madhavan et al. (1997) price formation model to realistic order books with quote discretization and liquidity rebates. We postulate that liquidity providers observe a fundamental price which is continuous, efficient, and can assume values outside the interval spanned by the best quotes. We confirm the predictions of our price formation model with extensive empirical tests on large high-frequency datasets of 100 liquid Nasdaq stocks. Finally we use the model to propose an estimator of the fundamental price based on the rebate adjusted volume imbalance at the best quotes and we empirically show that it outperforms other simpler estimators.
Liquidity provision; Market microstructure; Price formation; Tick size; Statistics and Probability; Condensed Matter Physics
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Utilizza questo identificativo per citare o creare un link a questo documento: https://hdl.handle.net/11384/83618
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