Market Order Flows, Limit Order Flows and Returns: Theory and Evidence

51 Pages Posted: 27 Nov 2015 Last revised: 1 Apr 2018

See all articles by Roman Kozhan

Roman Kozhan

University of Warwick - Warwick Business School

Michael Moore

University of Warwick - Warwick Business School

Richard Payne

City University London - The Business School

Multiple version iconThere are 2 versions of this paper

Date Written: March 26, 2018

Abstract

We study the relation between limit order flow, market order flow and returns. We develop a model where market-makers face inventory risk and adverse selection and show how prices depend on market and limit order flows. In the model, market-makers receive information through trade with customers and optimally split their subsequent trading between market and limit orders so as to exploit this information while controlling risk. Both types of order convey information and impact prices. Empirically, we show that adding limit order flows to regressions of (FX and equity) returns on market order flows greatly improves explanatory power. The price impact of limit orders is positive and smaller than that of market orders. Omitting limit order flows from the regression causes a large downward bias in the price impact of market orders. Thus there is evidence that traders speculate using a combination of limit orders and market orders.

Keywords: Market order flow, limit order flow, price discovery

JEL Classification: F31, G12, G15

Suggested Citation

Kozhan, Roman and Moore, Michael John and Payne, Richard G., Market Order Flows, Limit Order Flows and Returns: Theory and Evidence (March 26, 2018). Available at SSRN: https://ssrn.com/abstract=2695705 or http://dx.doi.org/10.2139/ssrn.2695705

Roman Kozhan

University of Warwick - Warwick Business School ( email )

Coventry CV4 7AL
United Kingdom

Michael John Moore (Contact Author)

University of Warwick - Warwick Business School ( email )

Coventry CV4 7AL
United Kingdom

Richard G. Payne

City University London - The Business School ( email )

106 Bunhill Row
London, EC1Y 8TZ
United Kingdom

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