“Monitoring and Limit Order Submission Risks” by Raymond LIU
University of New South Wales
This paper provides a formal analysis on the trade-off between monitoring and the risks of limit order submission. In the presence of uncertainty regarding the date of information arrival, limit order traders face the risk of being picked off (free trading option) and the risk of non-execution. To reduce these risks, they can either (i) widen the spread or (ii) exert some effort in learning the arrival date of information and react promptly before others. With the latter option, traders must bear the cost of monitoring. Traders choose to monitor only if its benefit outweighs its cost. We show that, due to this trade-off, when the cost of monitoring is too high, patient traders forgo the option to withdraw/revise and the equilibrium (competitive) bid-ask spread is the spread without endogenous monitoring. If the cost of monitoring is sufficiently small, the option to withdraw/revise can reduce the expected loss from both risks. The equilibrium bid-ask spread is tighter since traders behave competitively. The reduction in spread is captured by a Nash equilibrium of monitoring efforts exerted by limit order submitters and newswatchers who strive to profit from exercising in-the-money free trading options. We derive several testable hypotheses and test them using count regression models. Our empirical results correspond to the theoretical prediction.