The loan spread due to order processing costs
Parlour’s (1998) model considers the choice between market and limit orders to show the working of a limit order book. In her simplified world there are only strategic risk-neutral liquidity traders who are endowed with a different evaluation of the risky asset and arrive randomly at the market to submit either a market order (MO) or a limit order (LO). The novelty of this model is precisely the choice of the type of order to submit. As will be clarified below, this is not a model of price formation, since it assumes an exogenously given bid–ask spread at which traders can submit their orders; however, it introduces the strategic interaction between traders and the state of the limit order book, which is an important element previously disregarded by the literature on the functioning of an LOB. Furthermore, this model does not consider asymmetric information on the fundamental value of the asset; since traders are endowed only with their personal evaluation of the asset, they cannot exploit any information on its future value; it follows that in this model there are no adverse selection costs, nor are there inventory costs, since there are no market-makers offering liquidity. The spread is simply due to order processing costs.