Abstract
The purpose of this study is to propose a structural market microstructure model and examine the intraday price and spread dynamics in a highly liquid market. We extend the model of Madhavan, Richardson, and Roomans to devise a comprehensive order indicator model that considers the order duration, order size, market liquidity, and most importantly, inventory holding costs. Our empirical analyses on the KOSPI200 futures market indicate that the inventory holding costs of liquidity suppliers explain a significant portion of model-implied spreads. Meanwhile, the duration and size of traded orders convey significant information content on the inventory holding component. Market liquidity is also an important consideration for futures traders who have to manage their inventory holding costs.
Highlights
We develop a comprehensive market microstructure model that considers various aspects of microstructure events to examine the intraday price dynamics and components of bid–ask spreads
After controlling for the inventory holding costs, we find that other market considerations such as the order duration, size, and market liquidity play significant roles in explaining the intraday price dynamics and bid–ask spread components, which justifies the comprehensiveness of our microstructure model
Analyzing the highly liquid KOSPI200 futures market dataset, we find that do the order duration and size have significant information content on the intraday price dynamics, but the inventory holding cost of liquidity suppliers explains a significant portion of model-implied spreads, indicating the important role of liquidity suppliers that previous studies have ignored
Summary
We develop a comprehensive market microstructure model that considers various aspects of microstructure events to examine the intraday price dynamics and components of bid–ask spreads. As claimed by Ahn et al (2002) and Hagströmer et al (2016), even in the order-driven markets, limit order traders play the role of liquidity suppliers, and their trading generates explicitly positive bid–ask spreads These liquidity suppliers can regard their inventory levels and holding costs as significant when deciding to submit orders. Changes in price and spread components caused by inventory holding costs should be considered to obtain further insight into the intraday price behavior and dynamics of financial markets Motivated by these limitations of the previous approaches, we suggest a further extended microstructure model that captures the effects of the order duration, size, and market liquidity, and most importantly, the inventory holding costs of liquidity suppliers. The information effects of order duration and size on the inventory holding component are significantly related to futures market variables such as the trading environment, asset price, liquidity level, volatility, and intraday time periods
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