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5.2.5 The impact of the bid-ask spread
In this instance we find a clear confirmation of Hypothesis (4). Traders’ preference
for aggressive market trading significantly decreases when the bid-ask spread rises.
Conversely, the aggressiveness of limit order trading increases. Hence, the higher
the bid-ask spread, the lower traders’ incentive to cross the market and to post a
market order on the opposite side. In this case, market agents are willing to bear
execution risk by posting limit orders. Interestingly, we find weak evidence for the
fact that a widening of the bid-ask spread also leads to a decline of the cancellation
intensity on both sides of the market. Hence, the decrease of the risk of nonexecution
induced by higher spreads reduces traders’ willingness to cancel pending
orders.
5.3 Summarizing the results
A. D. Hall, N. Hautsch
Overall, we find clear evidence that the arrival rate of aggressive market orders,
limit orders, and cancellations is affected by the state of the order book and that
the inclusion of order book variables significantly increases the goodness-of-fit of
the model. Regarding the impact of changes in the market depth and the
cumulated pending volume on order and cancellation aggressiveness, we find
clear support for the “crowding-out” concept of Parlour (1998). These results are
in line with previous empirical studies such as Griffiths et al. (2000), Coppejans
and Domowitz (2002), Pascual and Veredas (2004) and Ranaldo (2004). In this
context, we also observe relationships which support the notion that the limit
order book has information value, i.e. that traders infer from the book with respect
to future price movements. However, Parlour’s model has no explanatory power
for the reaction of order aggressiveness after the occurrence of mid-quote
movements in the recent past. In this context, liquidity effects seem to prevail.
Furthermore, implications of the Foucault (1999) model regarding the impact of
volatility and the size of the bid-ask spread on traders’ order aggressiveness are
only partly confirmed. Whereas we find a significant crowding out of market
order aggressiveness towards limit order aggressiveness after a widening of the
spread (as theoretically predicted), we do not observe corresponding effects in
response to changes in the volatility. These peculiarities are not suggested by
existing equilibrium models.
Nevertheless, our findings suggest that a separate modelling of the single
processes in a multivariate setting is a valuable strategy providing a clear-cut
picture of how the particular processes are individually affected by the state of the
order book. Obviously, limit orders cannot necessarily be treated as less aggressive
versions of market orders since they respond in a different way to certain order
book variables. In this sense we confirm the results of Coppejans and Domowitz
(2002).
It is also demonstrated that the order book effects remain remarkably stable
irrespective of whether order book dynamics are taken into account or not. While
this finding illustrates the robustness of the results, it also implies that the economic
relations hold conditionally on the history of the individual processes as well as
unconditionally.