(no abstract available)

This paper provides microstructure models of order-driven market to analyze the dynamic dependencies of order strategy, price formation and order book information. This study gradually derives three models to shed light on those dynamic dependencies: risk-neutral order-submission model, risk-averse order-submission model and revision order-submission model based on order book information. Those inferences support that the order-driven market dynamically adjusts the bid/ask at any moment to generate enough price improvement return in order to cover the fluctuations of the adverse selection risk and the non-execution risk faced by limit order submitters of both side. In risk-neutral order-submission model, the model anatomizes adverse selection cost and bid-ask spread under risk-neutral preference of order submitters. This study finds that adverse selection cost comprises three components: arrival probability of informed traders, execution probability of setting price of limit order, cost-to-benefit ratio of investment. In risk-averse order-submission model, the model analyzes the optimal order-submission behavior of risk-averse uninformed traders. This study finds that the asset volatility is the key determinant of the adverse selection risk and the non-execution risk, and thereby the bid-ask spread is associated with the asset volatility. The novelty approach of this model could connect both previous risk-neutral models of Handa, Schwartz and Tiwari (2003) and Foucault (1999), which are the special cases of the reduced form of this model. In revision order-submission model, the model analyzes adverse selection costs and price formation of bid-ask spread, dynamically adjusted by previous state of limit order book in an electronic limit order market. Using order book data from the Taiwan Stock Exchange, the empirical analysis corroborates the following findings: (1) the state of the limit order book significantly affects subsequent order aggressiveness; (2) adverse selection cost and spread are negatively associated with the precision of order book information; (3) information effects of limit order book on the bid-ask spread provide strong support for the model.