Limit order markets, liquidity, and price impact

In this thesis, I explore various aspects of market liquidity and analyze its effect on asset prices. First, in a model of a limit order market I explain how to define liquidity and derive a price impact function. Second, I show how agents who have price impact generate a liquidity component in asset prices. In Part I, I propose a continuous-time model of price formation in a limit-order market. Strategic liquidity traders arrive randomly to the market and dynamically choose between limit and market orders, trading off execution price with waiting costs. I prove the existence of a Markov equilibrium in which the bid and ask prices depend only on the numbers of buy and sell orders in the book, and which can be characterized in closed-form in several cases of interest. My model generates empirically verified implications for the shape of the limit-order book and the dynamics of prices and trades. In particular, I show that buy and sell orders can in some cases cluster away from the bid-ask spread, thus generating a concave price impact function. In Part II, I lay the foundations for the model in Part I by explaining how to define multi- stage games with perfect information in continuous time. In this version, strategies are locally constant and have a finite number of jumps. Also, I allow for the possibility of "stopping the clock."