A Dynamic Market Microstructure Model with Market Orders and Random Order Book Depth

Abstract

This paper studies a dynamic market microstructure model, in which a strategic market maker competes with an informed trader. We include the presence of noise traders and limit order traders in our setup. Our model is a N-period model. We give necessary and sufficient conditions for an equilibrium to exist and provide conditions for it to be unique. Moreover, both the informed trader and the market maker try to maximize their profits. The resulting recursive equations lead to various economic interpretations. We investigate the interplay of different information sets. Finally we consider the competitive situation for the market maker. Our framework is general enough to obtain several well-known models as a particular case, among them the models by Kyle (1985) as well as Bondarenko and Sung (2003).