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Chapter 5

Estimating the Determinants of

Market Illiquidity

5.6 Exercises

2. Empirical specification of price impact regressions. Suppose that the

midprice at time t, mt , is determined by the best estimate of the stocks fundamental
value based on the public information available, namely t1 + "t , minus a term
reflecting the net inventory position zt of market makers at time t:

mt = t1 + "t zt ,

where the inventory at time t is related to the order flow at time t1 by the identity:

zt = zt1 qt1 .

When market makers receive an order qt at time t, they update their estimate of the
fundamental value t1 + "t to also reflect the innovation in order flow, qt E[qt |t ]:

t = t1 + {qt E[qt |t ]} + "t .

Finally, the order flow is generated by the following AR(2) process:

qt = 1 qt1 + 2 qt2 + t ,

where t is a zero-mean error term uncorrelated with all information at time t (i.e.,
all variables in the information set t ).

a. Define the unexpected component of the order flow, qt E[qt |t ], as a function

of the current and past values of the order flow.
b. Determine the change in the best estimate of the fundamental value, t .
c. Determine the change in the midprice, mt , as a function only of past values
of the order flow.

d. If you estimate the equation for mt obtained at point (c) jointly with the
order flow process assumed in equation qt = 1 qt1 + 2 qt2 + t , can you identify
the parameters of the model, namely, , , 1 , and 2 ? If so, explain how you would
infer their values, denoting the coecients of first three lags of the order flow in the
equation obtained at point (c) by b0 , b1 , and b2 .
e. Do we actually have over-identifying restrictions that can be tested? Specifi-
cally, does the above model imply a testable restriction on b1 /b2 ?

4. PIN estimation. This exercise uses data from the German Stock Ex-
change (a subset of the data set used in Grammig, Schiereck, and Theissen, 2001).13
The data set gives, for one stock (BVM) traded on the German Stock Exchange,
the number of buy orders and sell orders from June 2 to July 31, 1997 (forty-two
days). As usual, the orders are signed according to the position taken by liquidity
demanders (i.e., an order is signed positively when the trade initiator is a buyer
and conversely). The stock trades on two markets that operate in parallel: a floor
market and an electronic trading system. The main dierence between the two sys-
tems is relative anonymity: a floor market is less anonymous as traders on the floor
negotiate prices one-on-one. The data are stored in the Excel file Ch5_ex4_data.xls
and Ch5_ex4_data.dta available on the companion website for the book. This file
contains four time series:

1. buy_f: The number of buy orders executed in the floor market on each day
t, t 2 {1, ... , 42}.

2. sell_f : The number of sell orders executed in the floor market on each day t,
t 2 {1, ... , 42}.
We thank Erik Theissen for providing the data used here.

3. buy_e: The number of buy orders executed in the electronic market on each
day t, t 2 {1, ... , 42}.

4. sell_e : The number of sell orders executed in the electronic market on each
day t, t 2 {1, ... , 42}.

a. Consider the tree describing the order arrival process in figure 5.3. We modify
it to account for the possibility that traders can choose to trade in either the floor
market or the electronic market. Specifically, we suppose that informed investors
trade at rate F in the floor market and at rate E in the electronic market, while
uninformed investors buy and sell at rates "bj and "sj in market j 2 {E, F }. On
these assumptions, what is the likelihood that this trade is informed, conditional on
a trade taking place in the floor market? Conditional on a trade taking place in the
electronic market? Call these likelihoods PINF and PINE .

b. Using the series of buy and sell orders executed in each system, propose and
implement a methodology to estimate PINF and PINE .

(Note: Estimation by maximum likelihood may not converge if the initial values
for the parameters are not well chosen. For this you must calibrate the initial values
of the parameters to estimate, so that at least the average number of buy and sell
orders per day on each market implied by the Poisson distributions match the actual
averages in the data.)

c. Are informed traders more likely to trade in the anonymous market? Is adverse
selection greater in the anonymous market?

5.7 Solutions

Exercise 2:
a. From qt = 1 qt1 + 2 qt2 + t , we have:

qt E[qt |t ] = qt 1 qt1 2 qt2

b. Combining qt E[qt |t ] = qt 1 qt1 2 qt2 and t = t1 +{qt E[qt |t ]}+

"t yields:

t = qt 1 qt1 2 qt2 + "t

c. Dierencing mt = t1 + "t zt and combining it with zt = zt1 qt1 yields:

mt = t1 + "t zt = t1 + "t qt1

Lagging t = qt 1 qt1 2 qt2 + "t once, one obtains:

t1 = qt1 1 qt2 2 qt3 + "t1

Upon combining these two expressions, we obtain:

mt = ( + )qt1 1 qt2 2 qt3 + "t

where b0 = ( + ), b1 = 1 and b2 2 .
d. The parameters can be identified as follows:

b1 b2 b1 b2
= = and = b0 = b0
1 2 1 2

Of course, 1 and 2 are obtained by estimating qt = 1 qt1 + 2 qt2 + t .
e. There are over-identifying restrictions, since under point (d) we saw that there
b1 1
are two dierent ways to infer both and . The testable restriction is b2
= 2
since according to the model these two ratios should both equal .

Exercise 4: The program that produces the results reported below is the Stata do
file, which uses the Stata data file Ch5_ex4_data.dta
a. We have

PINE = (5.32)
bE + sE + E
PINF = . (5.33)
bF + sF + F

b. The unconditional probability of getting BnF buy orders on the floor market,
BnE buy orders on the electronic market, SnF sell orders on the floor market and
SnE sell orders on the electronic market on a specific day, is:
" #
(sF )SnF esF BbF
nF (bF )
e ( sE ) SnE sE BnE (bE )
e bE e
Prob(BnF , BnE , SnF, SnE ) = (1)
SnF ! BnF ! SnE ! BnE !
" #
(sF + F )SnF e(sF +F ) B
nF (bF )
e ( sE + E ) SnE (sF +E ) BnE (bE )
e bE e
SnF ! BnF ! SnE ! BnE !
" #
(sF )SnF es (bF + F )BnF e(bF +F ) (sE )SnE esE (bE + E )BnE e(sE +E )
+(1) .
SnF ! BnF ! SnE ! BnE !

We estimate the 8 parameters of this likelihood function through maximum like-

lihood. We obtain the following point estimates: = 0.21, = 0.33, E = 60.17,
F = 11.61, sF = 13.39, bF = 12.72, sE = 21.51, bE = 20.32. All coecients
are significantly dierent from zero. We deduce two estimates of PINE and PINF .


PINE = = 0.23 (5.34)
bE + sE + E
PINF = = 0.085 (5.35)
bF + sF + F

c. In line with eceonomic intuition, the intensity of informed traders arrival is

much higher in the electronic market than in the floor market (E = 60.17 >> F =
11.61). This does not immediately imply that adverse selection is smaller in the floor
market since the uninformed traders arrival intensities are also smaller in the floor
market. Thus, conditional on a trade taking place, the likelihood that this trade is
informed could be higher in the floor market. But this is not the case since PINF is
much smaller than PINE .