BizViews - Can Liquidity be Predicted?

Assistant Professors Kang Wenjin and Yeo Wee Yong conducted a comprehensive analysis for the New York Stock Exchange (NYSE) limit order book. This was done at both the aggregate market-level and the individual stock-level, and based on a sample covering all the NYSE ordinary stocks. Through this study, the authors gained a better understanding of the liquidity in the market and, among other findings, are now able to predict market liquidity.

All over the world, market design has been moving towards that of a pure limit order book.

A limit order book is a record of the orders placed with a brokerage to buy or sell a set number of shares at a specified price or better.

Traditionally, market makers bear the risk of holding a certain number of shares of a particular security in order to facilitate trading in that security.

They compete for customer order flow by showing buy and sell quotations for a guaranteed number of shares. Once an order is received, market makers immediately sell from their inventory or look for an offsetting order. This process happens within seconds.

In recent years, there has been a conversion of traditional dealer markets to hybrid or even pure limit order markets. New markets are being set up as pure limit order books, diminishing the roles of market makers.

For instance, Electronic Communication Networks (ECNs) eliminates the role of the third-party, making it one of the new alternative trading platforms which acts like limit order exchanges. Brokerages and individuals are now connected, trading directly between themselves.

Such a trend has drawn substantial amount of attention from academic scholars.

Limit order book and market design

Given the importance of liquidity in asset pricing and market efficiency, a better understanding of the limit order book and its liquidity provision can improve the design and regulation of financial exchanges and ultimately, the investor's welfare.

In order to study the different dimensions of the limit order book and the liquidity it provides, Asst Profs Kang and Yeo looked at the New York Stock Exchange (NYSE) and its historical data on the limit order book that was previously unavailable to the public.

Through detailed study at both aggregate market level, and individual stock level, they even discovered that market liquidity can be predicted from the information in the limit order book.

Liquidity beyond best quote posted

In the past, the only information about the market available was the best quote. Best quote is the highest buying price or the lowest selling price for a particular stock.

Without information about the second best, or the third best quote, it was difficult to ascertain just how liquid the market was.

The authors found that by looking at a series of quotes following the best quote, they were able to ascertain the liquidity of the market. They also found that the limit order book provides reasonable liquidity for large-size market-order trading.

More interestingly, the authors found that they were able to predict market liquidity using the methods they described in their research.

Future research

The authors suggested that future research could seek to better understand the variation of the liquidity provided by limit order book on an intraday basis. With the data set used in their paper, this will be feasible.

They also felt it would be interesting to look deeper into a theoretical understanding about how volatility affects limit order traders' trading strategy.

The above is an extract from the working paper, "Liquidity Beyond the Best Quote: A Study of the NYSE Limit Order Book". Dr Yeo Wee Yong is an Assistant Professor with the NUS Business School. He obtained his PhD in Finance from the Indiana University (Bloomington) and co-wrote this working paper with fellow colleague at the NUS Business School, Assistant Professor Kang Wenjin, who obtained his PhD from the Anderson School of Management, UCLA.

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