Risk aversion, order strategy and price formation

This article provides a model of order-submission strategy and price formation by analysing the optimal behaviour of risk-averse uninformed traders. According to our inference, the market dynamically adjusts the bid/ask at any moment to generate enough price improvement return in order to cover the adverse selection risk and the nonexecution risk faced by the liquidity providers of both side. We find that the asset volatility is the key determinant of the adverse selection risk and the nonexecution risk, and thereby the bid-ask spread is positively associated with the asset volatility. From a practice perspective, our order-submission model based on risk-averse preference may have much less potential problems than the risk-neutral analyses of Foucault (1999) and Handa et al. (2003). Besides, our novelty approach could connect both previous models, which are the special cases of the reduced form of our model.