Abstract
How does informed trading affect liquidity in order driven markets, where traders can choose between market orders (demanding liquidity) and limit orders (providing liquidity)? In a dynamic model of order driven markets we find that informed trading overall helps liquidity: a higher share of informed traders (i) improves liquidity as proxied by the bid-ask spread and market resiliency, and (ii) has no effect on the price impact of orders. The model generates other testable implications, and suggests new measures of informed trading.
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