AFFI International Conference 2017

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Risk aversion, order placement strategies and price formation in a dynamic limit order book: the perspective of European carbon markets

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An order placement model is proposed to investigate the mechanisms of price formation in a limit order book used for commodity trading.
The adverse selection costs of risk averse uninformed sellers (resp. buyers) are positively (resp. negatively) related to the arrival rates of market buy (resp. sell) orders. Next, the bid-ask spread is decomposed in three factors: differences in risk-adjusted asset valuations, the adverse selection costs of uninformed buyers and sellers respectively if an equivalent arrival rate of buy and sell market orders is expected.
Analyzing European carbon futures confirms and enriches these findings. If the bid-ask spread (resp. buyers’ adverse selection costs) follows an intraday U-(resp. inverted U-) shaped pattern, the diagonal effect that commands the arrival of market orders is successively explained by adverse selection, a quicker liquidity-replenishment cycle and order splitting strategies.

Author(s):

Yves Rannou    
Groupe ESC Clermont
France

 

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