Liquidity Supply and Demand in Limit Order Markets

We model a trader's decision to supply liquidity by submitting limit orders or demand liquidity by submitting market orders in a limit order market. The best quotes and the execution probabilities and picking off risks of limit orders determine the price of immediacy. The price of immediacy and the trader's willingness to pay for immediacy determine the trader's optimal order submission, with the trader's willingness to pay for immediacy depending on the trader's valuation for the stock. We estimate the execution probabilities and the picking off risks using a sample from the Vancouver Stock Exchange to compute the price of immediacy. The price of immediacy changes with market conditions - a trader's optimal order submission changes with market conditions. We combine the price of immediacy with the actual order submissions to estimate the unobserved arrival rates of traders and the distribution of the traders' valuations. High realized stock volatility increases the arrival rate of traders and increases the number of value traders arriving - liquidity supply is more competitive after periods of high volatility. An increase in the spread decreases the arrival rate of traders and decreases the number of value traders arriving - liquidity supply is less competitive when the spread widens