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Some recent evolutions in order book modelling Frédéric Abergel Chair of Quantitative Finance École Centrale Paris http://fiquant.mas.ecp.fr

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Order book modelling Joint work with I. Muni Toke, A. Jedidi Some references I. Muni Toke, Market making behaviour and its impact on the Bid-Ask spread, in Econophysics of Order-driven Markets, Abergel, F.; Chakrabarti, B.K.; Chakraborti, A.; Mitra, M. (Eds.), Springer, 2011 F. Abergel, A. Jedidi, A mathematical approach to order book modelling, in Econophysics of Order-driven Markets, Abergel, F.; Chakrabarti, B.K.; Chakraborti, A.; Mitra, M. (Eds.), Springer, 2011 F. Abergel, A. Jedidi, Stability and long time behaviour of a markovian order book model, to appear F. Abergel, A. Chakraborti, I. Muni Toke, M. Patriarca, Econophysics I: empirical facts and Econophysics II: agent-based models, to appear in Quantitative Finance

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Order book modelling Summary Empirical studies of the order book Stationary statistical properties Dynamical statistical properties Mathematical modelling Mathematical framework Price dynamics

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Statistical properties I A host of empirical studies going back to ~20 years Limit order price and volume distribution Spread distribution Inter-event durations Under independence assumptions: Zero-intelligence models

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Statistical properties II More recent studies (Bouchaud, Farmer, Large 2007, Muni Toke 2010, Eisler 2010) Studies of conditional distributions… … or conditional inter-event duration Structure of the order flow Empirical measurement of Volatility Clustering Market making… … and market taking Leading to models involving State-dependent intensities Mutually excited processes

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Statistical properties II Market making Following a market order New limit orders arrive more rapidly than unconditional limit orders No significant correlation between the respective signs of the market and limit orders

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Statistical properties II Market taking Following a limit order New market orders do not arrive more rapidly… … except when the limit order fell within the spread

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Statistical properties II Spread distribution An obvious counter-example to the zero-intelligence assumption: spread distribution

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Mathematical framework The order book is a pure jump vector-valued stochastic processes Arrival of events of various types Conditional on their occurrence, the events have a probabilistic description Choices have to be made Some technical: Fixed price grid (Cont, Stoikov, Talreja), fixed number of ticks, fixed number of limits with gaps… Initial distribution, boundary conditions… Some fundamental Exogenous and endogenous driving factors Dependence structure Main questions to be addressed Stationarity and long time behaviour Price and spread dynamics Scaling limits: lot size, tick size…

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Mathematical framework The simplest example: zero-intelligence with limit orders, market orders and cancellations (Farmer, Smith, Guillemot, Krishnamurthy, 2003)

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Mathematical framework Two sets of variables Coupled dynamics Two basic types of events Jump: a change in the quantities Shift : renumbering after a change of one of the best quotes

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Mathematical framework The infinitesimal generator of the associated Markov process

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Mathematical framework Example: shift on the Ask side following a sell market order

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Stationarity In this simple model, there exists a stationary distribution (Lyapunov function)… … thanks to the damping effect of cancellations This result is easily extended to state-dependent intensities ( provided the Lyapunov function still exists ) Remark: a methodological difficulty Cancellations are not always identified in financial databases… … therefore, one of the key parameters for stationarity may not be observable! Model calibration (Mike, Farmer, 2008) may be impaired

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Price dynamics Price dynamics depend on Events affecting the best limits The first gap process A useful representation for the best Ask and Bid prices:

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Price dynamics The expressions above provide a natural interpretation of the price changes: they are due to New limit orders that fall within the spread, for which one can safely assume some independence assumptions Events that modify the best quotes (either cancellations or market orders), for which the price changes depends on the first gaps and The price process has the following representation A Bachelier market has a similar representation with i.i.d. marks The marks may be assumed to be identically distributed (under stationarity), but not independent. The long time dynamics is extremely sensitive to the dependence structure of these processes

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Price dynamics A mathematical result (finally…) The centered price process in a zero-intelligence model with proportional cancellation rate scales to a brownian motion in the long time limit A first general result relating order book models and classical price models The spurrious randomness of the volatility due to the memory of the order book vanishes exponentially fast in this simple case Extensions to state dependent intensities, Hawkes processes Some interesting cases (ex. heavy traffic situations) are not covered

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Order book modelling Conclusion Empirical studies of the order book A large body of empirical results Conditional quantities contain a lot of relevant information The behaviour of market participants at the best limits tends to control the dynamics of price and spread Cancellation rate difficult to estimate (depending on data quality!) Mathematical modelling A general framework suitable for many extensions A result bridging the gap between order book dynamics and price process The structure of cancellations is the clue for stationarity Plenty of room for improvement: phenomenological models for the intensities, mean field games, heterogenous agents…

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