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The Price of Immediacy
Author(s) -
CHACKO GEORGE C.,
JUREK JAKUB W.,
STAFFORD ERIK
Publication year - 2008
Publication title -
the journal of finance
Language(s) - English
Resource type - Journals
SCImago Journal Rank - 18.151
H-Index - 299
eISSN - 1540-6261
pISSN - 0022-1082
DOI - 10.1111/j.1540-6261.2008.01357.x
Subject(s) - monopolistic competition , economics , limit (mathematics) , transaction cost , market maker , order (exchange) , database transaction , immediacy , economic rent , sample (material) , econometrics , microeconomics , monopoly , finance , computer science , mathematics , mathematical analysis , paleontology , philosophy , chemistry , horse , epistemology , chromatography , stock market , programming language , biology
This paper models transaction costs as the rents that a monopolistic market maker extracts from impatient investors who trade via limit orders. We show that limit orders are American options. The limit prices inducing immediate execution of the order are functionally equivalent to bid and ask prices and can be solved for various transaction sizes to characterize the market maker's entire supply curve. We find considerable empirical support for the model's predictions in the cross‐section of NYSE firms. The model produces unbiased, out‐of‐sample forecasts of abnormal returns for firms added to the S&P 500 index.