Category Archives: Aids finance

The models presented in the previous chapters describe the price formation process in markets with different  structures. As we saw in the previous article, among the markets with trade pricing rules, those governed by an order-driven execution system can be organized either as a continuous or as a call auction, while markets with a quote-driven system can be either a bilateral dealer market or a continuous auction that works as a limit order book.Within this outline, the Glosten and Milgrom (1985) model describes a bilateral quote-driven market in which dealers’ competition guarantees semi-strong efficiency; Kyle’s (1985) model proxies an order-driven call auction market where a specialist, or a number of market-makers, sets the market-clearing price after observing his, or their, customers’ aggregated order flow. Finally, the Grossman and Stiglitz (1980) model proxies an order-driven market where all participants can submit their demand schedules simultaneously.1 Since each demand function is a fairly accurate representation of a large number of small limit orders (Brown and Zhang, 1997), this market can be interpreted as a limit order book. As the next section shows, this interpretation has the advantage of considering all market participants as potential liquidity suppliers, i.e. of embodying the order-driven feature of a limit order book (LOB); it fails, however, to incorporate either the discriminatory pricing rule that characterizes  an LOB or the agents’ strategic choices between limit orders and market orders. Section8.1 will introduce the reader to the discriminatory pricing rule and will sketch a basic model that embodies this rule; in this model, however, agents cannot choose the type of order to submit to the LOB, so section 8.2 presents models in which the choice between market and limit orders is endogenous.