High Frequency Trading and Limit Order Book Dynamics

Ingmar Nolte, Mark Salmon, Chris Adcock, Ingmar Nolte, Mark Salmon, Chris Adcock

• Publisher: Taylor & Francis
• Year: 2016
• eBook ISBN: 9781317570769
• Edition: 1
• Topic: Business
• Subtopic: Economic Theory
• Index: Business

This book brings together the latest research in the areas of market microstructure and high-frequency finance along with new econometric methods to address critical practical issues in these areas of research. Thirteen chapters, each of which makes a valuable and significant contribution to the existing literature have been brought together, spanning a wide range of topics including information asymmetry and the information content in limit order books, high-frequency return distribution models, multivariate volatility forecasting, analysis of individual trading behaviour, the analysis of liquidity, price discovery across markets, market microstructure models and the information content of order flow. These issues are central both to the rapidly expanding practice of high frequency trading in financial markets and to the further development of the academic literature in this area. The volume will therefore be of immediate interest to practitioners and academics.

This book was originally published as a special issue of European Journal of Finance.

Introduction

 

 

This book reflects the conference, ‘Individual Decision Making, High Frequency Econometrics and Limit Order Book Dynamics’, that took place at Warwick Business School in September 2009. The conference was organised by Roman Kozhan, Ingmar Nolte, Richard Payne and Mark Salmon with the aim of bringing together leading experts, academics, PhD students and members of the finance industry working in the areas of market microstructure, high-frequency finance and behavioural finance to discuss the latest research in these fields. Thirteen selected articles covering the state-of-the-art research in these areas have been brought together here after a rigorous refereeing process. Each paper makes a valuable and significant contribution to the existing literature and we hope that you will enjoy reading them.

Beltran-Lopez, Grammig and Menkveld analyse the link between information asymmetry and market liquidity. They study the importance of information asymmetry in limit order books based on a recent sample of 30 German DAX stocks and find that Hasbrouck’s measure of trade informativeness Granger causes book liquidity, in particular that required to fill large market orders. They find that picking-off risk due to public news-induced volatility is more important for top-of-the book liquidity supply. In their multivariate analysis they control for volatility, trading volume, trading intensity and order imbalance to isolate the effect of trade informativeness on book liquidity.

Bonato, Caporin and Ranaldo focus within the class of realized covariance models on Wishart specifications and analyse the forecasting performance of parametric restrictions motivated by asset features such as their economic sector, book-to-market or price-earnings ratios. They consider a range of model comparison approaches that represent the most recent and up-to-date methods proposed in the literature. Their tests provide some evidence on the possible preference of restricted specifications over fully parameterized models.

Coroneo and Veredas model the conditional distribution of high-frequency financial returns by means of a two-component quantile regression model. Using three years of 30-minute returns, they show that the conditional distribution depends on past returns and on the time of the day. Two practical applications illustrate the usefulness of the model. First, they provide quantile-based measures of conditional volatility, asymmetry and kurtosis that do not depend on the existence of moments. They find seasonal patterns and time dependencies beyond volatility. Second, they estimate and forecast intraday Value at Risk and show that their two-component model is able to provide good risk assessments and to outperform GARCH-based Value at Risk methods.

Daníelsson and Payne exploit full-order level information from an electronic foreign exchange (FX) broking system to provide a comprehensive account of the determination of its liquidity. They not only look at bid–ask spreads and trading volumes, but also study the determination of order entry rates and depth measures derived from the entire limit order book. They find strong predictability in the arrival of liquidity supply/demand events. Further, in times of low (high) liquidity, liquidity supply (demand) events are more common. In times of high trading activity and volatility, the ratio of limit to market order arrivals is high but order book spreads and depth deteriorate. Their results are consistent with market order traders having better information than limit order traders.

Daníelsson, Luo and Payne investigate the dependence of FX rates on order flow for four major exchange rate pairs, EUR/USD, EUR/GBP, GBP/USD and USD/JPY, across sampling frequencies ranging from 5 minutes to 1 week. They discover strong explanatory power for all sampling frequencies and also uncover cross-market order flow effects, e.g. GBP exchange rates are very strongly influenced by EUR/USD order flow. They use the Meese and Rogoff framework to investigate the predictive power of order flow for exchange rate changes and show that the order flow specifications reduce RMSEs relative to a random walk for all exchange rates at high frequencies and for EUR/USD and USD/JPY at lower sampling frequencies.

Dufour and Nguyen analyse transaction data for euro-area sovereign bonds traded on the MTS electronic platforms. They measure the informational content of trading activity by estimating the permanent price response to trades. They find not only strong evidence of information asymmetry in sovereign bond markets, but also show the relevance of information asymmetry in explaining the cross-sectional variations of bond yields across a wide range of bond maturities and countries. Their results confirm that trades of more recently issued bonds and longer maturity bonds have a greater permanent effect on prices. They study the cross-section of bond yields and find that, after controlling for conventional factors, investors demand higher yields for bonds with a larger permanent trading impact. Interestingly, when investors face increased market uncertainty they require even higher compensation for information asymmetry.

Marsh and Miao consider the impact of FX order flows on contemporaneous and future stock market returns using a new database of customer order flows in the - exchange rate market as seen by a leading European bank. They do not find clear contemporaneous relationships between FX order flows and stock market changes at high frequencies, but FX flows do appear to have significant power to forecast stock index returns over 1-minute to 30-minute horizons, after controlling for lagged exchange rate and stock market returns. The effects of order flows from financial customers on future stock market changes are negative, while the effects of corporate orders are positive. Their latter results are consistent with the premise that corporate order flows contain dispersed, passively acquired information about fundamentals. Thus, purchases of the dollar by corporate customers represent good news about the state of the US economy. Importantly, though, there also appears to be extra information in corporate flows which is directly relevant to equity prices over and above the impact derived from stock prices reacting to (predicted) exchange rate changes. Their findings suggest that financial customer flows only affect stock prices through their impact on the value of the dollar.

Nolte uses a panel survival approach to analyse the trading behaviour of FX traders. He focuses on a detailed characterisation of the shape of the disposition effect over the entire profit and loss region. Thereby he investigates the influence of trading characteristics such as special limit order strategies, trading success, size and investors’ experience on the disposition effect. His main findings are that (i) the disposition effect has a non-linear shape. For small profits and losses, there is an inverted disposition effect, while for larger ones the usual positive disposition effect emerges. (ii) The inverted disposition effect is driven to a great extent by patient and cautious investors closing their positions with special limit orders (take-profit and stop-loss). The normal positive disposition effect is found to be intensified for impatient investors closing their positions actively with market orders. (iii) He shows that unsuccessful investors reveal a stronger inverse disposition effect and provides evidence that bigger investors are less prone to the disposition effect than smaller investors.

Nolte and Nolte examine how high-frequency trading decisions of individual investors are influenced by past price changes. Specifically, they address the question as to whether decisions to open or close a position are different when investors already hold a position compared to when they do not. Based on a unique dataset from an electronic FX trading platform, OANDA FXTrade, they find that investors’ future order flow is (significantly) driven by past price movements and that these predictive patterns last up to several hours. This observation clearly shows that for high-frequency trading, investors rely on previous price movements in making future investment decisions. They provide clear evidence that market and limit orders’ flows are much more predictable if those orders are submitted to close an existing position than if they are used to open one. This finding provides evidence for the existence of a monitoring effect, which has implications for theoretical market microstructure models and behavioural finance phenomena, such as the endowment effect.

Pardo and Pascual investigate the informativeness of iceberg orders, also known as hidden limit orders (HLOs). They analyse how the market reacts when the presence of hidden volume in the limit order book is revealed by the trading process. They use high-frequency book and transaction data from the Spanish Stock Exchange, including a large sample of executed HLOs. They show that just when hidden volume is detected, traders on the opposite side of the market become more aggressive, exploiting the opportunity to consume more than expected at the best quotes. However, neither illiquidity nor volatility increases in the short-term. They also find that the detection of hidden volume has no relevant price impact. Overall, their results suggest that market participants do not attribute any relevant informational content to the hidden side of liquidity.

Theissen reconsiders the issue of price discovery in spot and futures markets. He uses a threshold error correction model to allow for arbitrage opportunities to have an impact on the return dynamics. He estimates the model using quote midpoints and modifies the model to account for time-varying transaction costs. He finds that (a) the futures market leads in the process of price discovery and that (b) the presence of arbitrage opportunities has a strong impact on the dynamics of the price discovery process.

Vitale formulates a market microstructure model of exchange determination, which he employs to investigate the impact of informed trading on exchange rates and conditions in the FX market. With his formulation he shows how strategic informed agents influence exchange rates via both the portfolio-balance and information effects. He outlines the connection which exists between the private value of information, market efficiency, liquidity and exchange rate volatility. His model is also consistent with recent empirical research on the microstructure of FX markets.

Wuyts investigates resiliency in an order-driven market. On basis of a VAR model capturing various dimensions of liquidity and their interactions, he simulates the effect of a large liquidity shock, measured by a very aggressive market order. He shows that, despite the absence of market makers, the market is resilient. All dimensions of liquidity (spread, depth at the best prices and order book imbalances) revert to their steady-state values within 15 orders after the shock. For prices, a long-run effect is found. Furthermore, he finds that different dimensions of liquidity interact. Immediately after a liquidity shock, the spread becomes wider than in the steady state, implying that one dimension of liquidity deteriorates, while at the same time depth at the best prices increases, implying an improvement of another liquidity dimension. In subsequent periods, the spread reverts not only to the steady-state level but also the depth decreases. He also finds evidence for asymmetries in the impact of shocks on the ask and bid side. Shocks on the ask side have a stronger impact than shocks on the bid side. His final result is that resiliency is higher for less frequently traded stocks and stocks with a larger relative tick size.

Ingmar Nolte

Lancaster University Management School, Lancaster University, Bailrigg, Lancaster, LA1 4YX, UK

Mark Salmon

Faculty of Economics, University of Cambridge, Cambridge, CB3 9DD, UK

Limit order books and trade informativeness

Hélena Beltran-Lopez^a, Joachim Grammig^b and Albert J. Menkveld^c

^aFifth Third Asset Management, Cleveland, USA; ^bDepartment of Economics, Eberhard-Karls-University Tübingen, Tübingen, Germany; ^cDepartment of Finance and Financial Sector Management, VU University Amsterdam, Amsterdam, The Netherlands

In the microstructure literature, information asymmetry is an important determinant of market liquidity. The classic setting is that uninformed dedicated liquidity suppliers charge price concessions when incoming market orders are likely to be informationally motivated. In limit order book (LOB) markets, however, this relationship is less clear, as market participants can switch roles, and freely choose to immediately demand or patiently supply liquidity by submitting either market or limit orders. We study the importance of information asymmetry in LOBs based on a recent sample of 30 German Deutscher Aktienindex (DAX) stocks. We find that Hasbrouck’s (1991) measure of trade informativeness Granger causes book liquidity, in particular that required to fill large market orders. Picking-off risk due to public news-induced volatility is more important for top-of-the book liquidity supply. In our multivariate analysis, we control for volatility, trading volume, trading intensity and order imbalance to isolate the effect of trade informativeness on book liquidity.

1. Introduction

The classic microstructure literature distinguishes liquidity suppliers and liquidity demanders, which naturally introduces information asymmetry. That is, liquidity suppliers trade against potentially privately informed liquidity demanders and charge them an increased price concession to protect themselves.¹ This deters uninformed, hedging-motivated liquidity demand and, in the extreme, might cause the market to break down. Information asymmetry thus reduces welfare (cf. Biais, Hillion and Spatt 2005, pp. 223–227). Easley, Hvidkjaer and O’Hara (2002) provide evidence that asymmetric information risk is priced, as stocks for which they estimate a high probability of informed trading have to offer higher expected returns.

With the advent of electronic limit order book (LOB) markets, howe...

Table of contents

• Cover
• Half Title
• Title Page
• Copyright
• Contents
• Citation Information
• Notes on Contributors
• 1. Introduction
• 2. Limit order books and trade informativeness
• 3. A forecast-based comparison of restricted Wishart autoregressive models for realized covariance matrices
• 4. A simple two-component model for the distribution of intraday returns
• 5. Liquidity determination in an order-driven market
• 6. Exchange rate determination and inter-market order flow effects
• 7. Permanent trading impacts and bond yields
• 8. High-frequency information content in end-user foreign exchange order flows
• 9. A detailed investigation of the disposition effect and individual trading behavior: a panel survival approach
• 10. How do individual investors trade?
• 11. On the hidden side of liquidity
• 12. Price discovery in spot and futures markets: a reconsideration
• 13. Optimal informed trading in the foreign exchange market
• 14. The impact of aggressive orders in an order-driven market: a simulation approach
• Index