Arbitrage-free Limit Order Books and the Pricing of Order Flow Risk
This paper builds on the landmark contribution of Glosten (1994) by treating the determination of limit order supply schedules as an exercise in asset pricing theory with the possible sizes of incoming market orders as the value-relevant states of nature, yielding an analogue of the Fundamental Theorem of Asset Pricing. State prices and price impact prove to be proportional to the slope of the book and simple nonparametric and semiparametric models for limit order book dynamics arise when the price of order flow risk is constant over time, providing a comprehensive and coherent framework for organizing limit order book data.
This research is part of the NBER's program on Asset Pricing and was supported in part by a Morgan Stanley Equity Microstructure Research Grant for which I am quite grateful. The views expressed herein are solely my own and not those of any other person or entity including Morgan Stanley and the National Bureau of Economic Research. I am grateful to Joel Hasbrouck and, especially, to Shmuel Baruch for helpful comments. I have also benefited from the comments of participants at the conferences in Honor of David K. Whitcomb at Rutgers University, on the Econometrics of the Microstructure of Financial Markets at Tilburg University, on the Analysis of High-Frequency Financial Data and Market Microstructure at Academia Sinica, and on the Workshop on Microstucture of Financial Markets at the Bolsa Madrid, and at the Morgan Stanley Equity Market Microstructure Research Conference. I am also indebted to seminar participants at Northwestern University, the Securities and Exchange Commission, and the University of Utah. All errors that remain are my own responsibility. The views expressed herein are those of the author(s) and do not necessarily reflect the views of the National Bureau of Economic Research.