- We model the dynamics of ask and bid curves in a limit order book market using a dynamic
semiparametric factor model. The shape of the curves is captured by a factor structure which
is estimated nonparametrically. Corresponding factor loadings are assumed to follow
multivariate dynamics and are modelled using a vector autoregressive model. Applying the
framework to four stocks traded at the Australian Stock Exchange (ASX) in 2002, we show
that the suggested model captures the spatial and temporal dependencies of the limit order
book. Relating the shape of the curves to variables reflecting the current state of the market,
we show that the recent liquidity demand has the strongest impact. In an extensive
forecasting analysis we show that the model is successful in forecasting the liquidity supply
over various time horizons during a trading day. Moreover, it is shown that the model’s
forecasting power can be used to improve optimal order execution strategies.