Stochastic Price Dynamics Implied By the Limit Order Book

Details Stochastic Price Dynamics Implied By the Limit Order Book Stochastic Price Dynamics Implied By the Limit Order Book

2011-05-24

arxiv.org/abs/1105.4789v1

Economy

Quantitative Finance

Trading and Market Microstructure

Limit order book, limit orders, volatility smile, jump process, double-exponential jump process, impatience rate, jump diffusi

Scientific paper

In this paper we present a novel approach to the determination of fat tails in financial data by studying the information contained in the limit order book. In an order-driven market buyers and sellers may submit limit orders, which are executed when the price touches a pre-specified lower, respectively higher, limit-price. We show that, in equilibrium, the collection of all such orders - the limit order book - implies a volatility smile, similar to observations from option pricing in the Black-Scholes model. We also show how a jump-diffusion process can be explicitly inferred to account for the volatility smile.

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