ADVANCES IN QUANTITATIVE ANALYSIS OF
FINANCE AND
ACCOUNTING
Essays in Microstructure in Honor of David K. Whitcomb
Volume 3
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ADVANCES IN QUANTITATIVE ANALYSIS OF
FINANCE AND
ACCOUNTING
Essays in Microstructure in Honor of David K. Whitcomb
Volume 3
Editors
Ivan E. Brick
Rutgers University, USA
Tavy Ronen
Rutgers University, USA
Cheng-Few Lee
Rutgers University, USA
World Scientific
NEW JERSEY . LONDON . SINGAPORE . BEIJING . SHANGHAI . HONG KONG . TAIPET. CHENNAI
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Contents
Preface to Volume 3 v
Introduction to Volume 3 ix
Ivan E. Brick, Tavy Ronen
List of Contributors xv
Section I — Economics of Limit Orders
Chapter 1 Discriminatory Limit Order Books,
Uniform Price Clearing and Optimality 3
Lawrence R. Glosten
Chapter 2 Electronic Limit Order Books and Market
Resiliency: Theory, Evidence, and Practice 19
Mark Coppejans, Ian Domowitz, Ananth Madhavan
Chapter 3 Notes for a Contingent Claims Theory of Limit
Order Markets 39
Bruce N. Lehmann
Chapter 4 The Option Value of the Limit Order Book 57
Alex Frino, Elvis Jarnecic, Thomas H. McInish
Section II — Essays on Liquidity of Markets
Chapter 5 The Cross Section of Daily Variation in Liquidity 75
Tarun Chordia, Lakshmanan Shivakumar,
Avanidhar Subrahmanyam
vii
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viii Contents
Chapter 6 Intraday Volatility on the NYSE and NASDAQ 111
Daniel G. Weaver
Chapter 7 The Intraday Probability of Informed
Trading on the NYSE 139
Michael A. Goldstein, Bonnie F. Van Ness,

In such, it can be viewed as way of thought, as opposed to a subfield.
A major contribution of microstructure can be seen in the advancement of
our understanding of market efficiency. In particular, we can now use intraday
data to examine the speed of information incorporation into security prices
when major corporate announcements take place. Similarly, our understanding
of asset pricing has been altered with the advent of high frequency data anal-
ysis. Traditional asset pricing models focus on the formation of equilibrium
security prices based upon the moments of distribution of the underlying cash
flows of the security and attribute changes in security prices to changes in infor-
mation structure of the market. In contrast, market microstructure recognizes
that the actual transaction prices and variances do not necessarily equal those
determined by our financial models. Thus, the emphasis of market microstruc-
ture becomes the study of the deviations between the transaction price and the
equilibrium price, with deviations attributed to such factors as liquidity, mar-
ket structure, transaction costs, and inventory-based adjustments. Clearly, the
growing body of research in this field has uncovered and revisited many of our
traditional theories, shedding new light on the interpretation of our markets.
This book is a tribute to the field of microstructure and to David K.
Whitcomb, Professor Emeritus at Rutgers University, who is one of its fore-
most pioneers. Like the field itself, David Whitcomb’s contributions have had
an impact both in their academic rigor and practical applications. His articles
ix
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x Ivan E. Brick & Tavy Ronen
have appeared in The American Economic Review, The International Journal
of Finance, The Journal of Banking and Finance, The Journal of Finance,
The Journal of Financial Economics, The Journal of Financial & Quantitative
Analysis, The Journal of Industrial Economics, The Journal of Money, Credit
& Banking, The Journal of Political Economy, Management Science, and The

This book is a collection of 11 original studies in the field of microstructure,
the first seven of which were presented at the conference in October 2002,
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Introduction xi
across different subareas, and each reflecting the future directions of research.
We have loosely divided the book into three sections: Economics of Limit
Orders, Essays on Liquidity of Markets and Market Rationality.
The first section of the book addresses the important issue of optimal limit
order book structure. This is a central focus of the microstructure literature
today, in part because of the growing use of the limit order book in most major
exchanges and markets, both domestically and internationally, in the trade of
equities, derivatives, bonds, and foreign exchange. The chapters in this book
that examine the optimality of the limit order book, as well as its character-
istics and resulting efficiency all take a different perspective in analyzing this
increasingly popular market mechanism. “Single Price Limit Order Books,
Discriminatory Limit Order Books, and Optimality,” by Lawrence Glosten
establishes that the limit order book is not only inevitable, as suggested by his
earlier paper, “Is the electronic limit order book inevitable?” (Glosten, Journal
of Finance, September 1994), but also optimal in most instances. The analysis
incorporates asymmetric information, inventory related costs and potential liq-
uidity difficulties in the derivation and characterization of the equilibrium. The
paper shows that a Centralized Limit order book is indeed optimal, implying
that if a regulatory authority could choose and protect a single market mecha-
nism, it would most probably choose the limit order book mechanism. Another
interesting result of the paper is that a uniform price clearing mechanism can
never be optimal in a setting where private information is present. The negative
profits that Glosten shows to exist in such an environment are surprising in
light of the fact that opening clearings on most exchanges use a uniform price
procedure.

potential arbitrage profit. This paper illustrates examples in which event time
and calendar time differ but can coincide such as to precede continuous trading
in most equity markets. The economics involve assuming that limit order traders
(as suppliers of liquidity) span desired trading in event time.
In “The Option Value of the Limit Order Book,” by Alex Frino, Elvis
Jarnecic and Thomas H. McInish, the option value of the limit order book
is calculated for a sample of ten actively traded stocks from the Australia Stock
Exchange at 11 a.m. each day. The authors find that the option value of the
limit order book is stable for the 11 a.m. snapshot over the sample period of
September 3 to December 31, 2001. Interestingly, they also find that 33.1% of
the option value of the limit order book is provided at the best ask and 34.7% at
the best bid. Moreover, the paper concludes that the option value of the entire
limit order book is more stable than both the value of an individual limit order
option and the number of shares in the limit order book during that time period.
The second section of the book deals with the liquidity of capital mar-
kets. The first chapter of this section is “The Cross-Section of Daily Varia-
tion in Liquidity,” by Tarun Chordia, Lakshmanan Shivakumar and Avanidhar
Subrahmanyam. This paper analyzes cross-sectional heterogeneity in the time-
series variation of liquidity in equity markets using a broad time series and
cross-section of liquidity data. The authors find that average daily changes
in liquidity exhibit significant heterogeneity in the cross-section; that is, the
liquidity of small firms varies more on a daily basis than that of large firms.
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Introduction xiii
A steady increase in aggregate market liquidity over the past decade is more
strongly manifested in large firms than in small firms. The absolute stock return
is an important determinant of liquidity. Cross-sectional differences in the
resilience of a firm’s liquidity to information shocks are analyzed. The sensitiv-
ity of stock liquidity to absolute stock returns is used as an inverse measure of

rates between 1995 and 2005 are a weighted average of past leasing returns and
a set of fundamental factors, including NYSE quoted spreads, NYSE trading
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xiv Ivan E. Brick & Tavy Ronen
volume and market return. Interestingly, past leasing returns are shown to have
a stronger impact upon current lease returns than do the fundamental factors.
The next chapter, “Decimalization and Market Quality,” by Robin K. Chou
and Wan-Chen Lee examines the impact of decimalization on the liquidity of
stocks traded in the NewYork Stock Exchange. Economic theory would suggest
that liquidity provided by market makers would be a function of the tick size.
By January 29, 2001, all NYSE stocks traded in tick sizes of $0.01. The authors
find that spreads decreased significantly after decimalization, but market depth
and average volume per trade decreases as well. The authors argue that these
results are due to front-runners, traders who offer marginally better prices to
gain priority pushing market makers who are willing to provide greater depth
to the market.
Section 3 of the book devotes itself to the rationality of the market. The
first paper of this section, “The Importance of Being Conservative: An Illus-
tration on Natural Selection in a Futures Market,” Guo Ying Luo presents an
evolutionary model of natural selection, with traders modeled as being pre-
programmed with inherent behavioral rules. Two distinct types of traders are
assumed. A conservative buyer has a lower probability of over-predicting the
spot price than other traders. A conservative seller has a lower probability of
under-predicting the spot price. Guo demonstrates that natural selection will
redistribute wealth from less conservative traders to more conservative traders.
As long as the conservative traders have some positive probability of making an
accurate prediction of the spot price, the presence of these traders will ensure
the convergence to an efficient market.
The final chapter of this section and book is “Speculative Non-Fundamental

Fax: (973)-353-1233
Email:
Chapter 1
Lawrence R. Glosten
School of Business
Columbia University
418A Uris Hall
New York, NY 10027-6902, USA
Tel.: (845)-887-4662
(212)-854-2476
xv
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xvi List of Contributors
Fax: (212)-316-9355
Email:
Chapter 2
Mark Coppejans
Barclays Global Investors
45 Fremont Street
San Francisco, CA 94105
Email:
Ian Domowitz
ITG Inc.
380 Madison Avenue
New York, NY 10017, USA
Tel.: (212)-444-6279
Email:
Ananth Madhavan
Barclays Global Investors

Thomas H. Mclnish
Fogleman College of Business and Economics
The University of Memphis
Memphis, TN 38152, USA
Tel.: (901)-678-4662
Fax: (901)-678-3006
Email:
Chapter 5
Tarun Chordia
Goizueta Business School
Emory University
1300 Clifton Road
Atlanta, GA 30322, USA
Tel.: (404)-727-1620
Fax: (404)-727-5238
Email:
Lakshmanan Shivakumar
London Business School
Sussex Place, Regent’s Park
London, NW1 4SA, UK
Tel.: 44-20-7262-5050 x.3333
Fax: 44-20-7724-6573
Email:
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xviii List of Contributors
Avanidhar Subrahmanyam
The Anderson School
University of California at Los Angeles
Los Angeles, CA 90095-1481, USA

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List of Contributors xix
Robert A. Van Ness
Department of Finance
University of Mississippi
School of Business
233 Holman Hall
MS 38677, USA
Tel.: (662)-915-6940
Email:
Chapter 8
Thomas O. Miller
Villanova University
College of Commerce and Finance
Villanova, PA 19085, USA
Tel.: (610)-519-4377
Fax: (610)-519-6881
Email:
Michael S. Pagano
Department of Finance
Villanova University
College of Commerce and Finance
Villanova, PA 19085, USA
Tel.: (610)-519-4389
Fax: (610)-519-6881
Email:
Chapter 9
Robin K. Chou
Department of Finance

Fax: 61-2-9385-6347
Email:
A. G. Malliaris
Department of Economics and Finance
Loyola University of Chicago
820 N. Michigan Avenue
Chicago, IL 60611, USA
Tel.: (312)-915-6063
Fax: (312)-915-8508
Email:
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Section I
Economics of Limit Orders
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Chapter 1
Discriminatory Limit Order Books, Uniform
Price Clearing and Optimality
Lawrence R. Glosten
Columbia Business School, USA
The paper provides new results on the optimality of a centralized limit order book. In an envi-
ronment in which traders optimally choose their trade quantity in response to the terms of trade
they face, the analysis shows that a centralized limit order book is optimal in the following
sense: the equilibrium in a limit order book corresponds to the welfare optimum for some set
of welfare weights. The paper also provides a new analysis of a uniform price limit order book
with endogenous trade.
Keywords: Market microstructure; market design; limit order markets.

literature that addresses the question of market design. It is most closely related
to Viswanathan and Wang (VW) (2000), which examines the welfare properties
of a discriminatory (each limit order pays of receives its limit price) CLOB with
the equilibrium in a market with a finite number of strategic dealers all trading at
the same price (or alternatively, a uniform price limit order book). The notable
difference between this paper and VW is that while the distribution of trade
sizes is specified exogenously in VW, this paper derives the equilibrium trade
distribution based on the exogenously specified distribution of trader “types.”
That is, based on an individual’s type and the terms of trade offered, the agent
decides how large a trade to make. As the analysis of VW shows, and this paper
confirms, the terms of trade determined by equilibrium in the discriminatory
price CLOB are quite different from that in a uniform price clearing. Thus, one
might expect the distributions of trade sizes to be different in the two settings.
Consideration of elastic trade demand also allows a measure of welfare which
includes the quoters. With inelastic trade, the cost to a trader is a benefit to the
quoters and hence the total surplus is unaffected.
As with the papers cited above, the analysis is of the market at a point in time.
Conceptually, the market is presumed to consist of a sequence ofsuchequilibria.
The paper does not analyze the trade-off between market orders and limitorders.
This requires a dynamic model and is beyond the scope of this paper.
The outline of the paper is as follows. Section 2 lays out the economic
environment and discusses the measure of welfare to be used. The subsequent
section analyzes the optimum market design given this measure of welfare. This
is followed by an analysis of equilibrium in a CLOB and a uniform price clear-
ing with the major welfare result. The paper concludes with some observations
on the relevance of the results for the regulation and design of markets.
2. The Economic Setting
The model to be analyzed considers the trade in a single security with a risky
payoff, X. All of the analysis will be in terms of deviations from the current
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