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Market efficiency and the long-memory of supply and demand: is price impact variable and permanent or fixed and temporary?

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Author Info

  • J. Doyne Farmer
  • Austin Gerig
  • Fabrizio Lillo
  • Szabolcs Mike

Abstract

In this comment we discuss the problem of reconciling the linear efficiency of price returns with the long-memory of supply and demand. We present new evidence that shows that efficiency is maintained by a liquidity imbalance that co-moves with the imbalance of buyer vs. seller initiated transactions. For example, during a period where there is an excess of buyer initiated transactions, there is also more liquidity for buy orders than sell orders, so that buy orders generate smaller and less frequent price responses than sell orders. At the moment a buy order is placed the transaction sign imbalance tends to dominate, generating a price impact. However, the liquidity imbalance rapidly increases with time, so that after a small number of time steps it cancels all the inefficiency caused by the transaction sign imbalance, bounding the price impact. While the view presented by Bouchaud et al. of a fixed and temporary bare price impact is self-consistent and formally correct, we argue that viewing this in terms of a variable but permanent price impact provides a simpler and more natural view. This is in the spirit of the original conjecture of Lillo and Farmer, but generalized to allow for finite time lags in the build up of the liquidity imbalance after a transaction. We discuss the possible strategic motivations that give rise to the liquidity imbalance and offer an alternative hypothesis. We also present some results that call into question the statistical significance of large swings in expected price impact at long times.

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Bibliographic Info

Article provided by Taylor & Francis Journals in its journal Quantitative Finance.

Volume (Year): 6 (2006)
Issue (Month): 2 ()
Pages: 107-112

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Handle: RePEc:taf:quantf:v:6:y:2006:i:2:p:107-112

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References

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  1. Jean-Philippe Bouchaud & Yuval Gefen & Marc Potters & Matthieu Wyart, 2004. "Fluctuations and response in financial markets: the subtle nature of 'random' price changes," Quantitative Finance, Taylor & Francis Journals, vol. 4(2), pages 176-190.
  2. Jean-Philippe Bouchaud & Yuval Gefen & Marc Potters & Matthieu Wyart, 2003. "Fluctuations and response in financial markets: the subtle nature of `random' price changes," Papers cond-mat/0307332, arXiv.org, revised Aug 2003.
  3. Jean-Philippe Bouchaud & Julien Kockelkoren & Marc Potters, 2006. "Random walks, liquidity molasses and critical response in financial markets," Quantitative Finance, Taylor & Francis Journals, vol. 6(2), pages 115-123.
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Citations

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Cited by:
  1. Frédéric Abergel & Aymen Jedidi, 2013. "A Mathematical Approach to Order Book Modelling," Post-Print hal-00621253, HAL.
  2. Bence Toth & Zoltan Eisler & Fabrizio Lillo & Julien Kockelkoren & Jean-Philippe Bouchaud & J. Doyne Farmer, 2011. "How does the market react to your order flow?," Papers 1104.0587, arXiv.org, revised May 2012.
  3. Jasmina Hasanhodzic & Andrew Lo & Emanuele Viola, 2011. "A computational view of market efficiency," Quantitative Finance, Taylor & Francis Journals, vol. 11(7), pages 1043-1050.
  4. Sorin Solomon & Natasa Golo, 2014. "Minsky Financial Instability, Interscale Feedback, Percolation and Marshall-Walras Disequilibrium," Papers 1402.0176, arXiv.org.
  5. J. Doyne Farmer & John Geanakoplos, 2008. "The virtues and vices of equilibrium and the future of financial economics," Papers 0803.2996, arXiv.org.
  6. Khalil al Dayri & Emmanuel Bacry & Jean-Francois Muzy, 2010. "The nature of price returns during periods of high market activity," Papers 1010.4226, arXiv.org, revised Oct 2010.
  7. Jean-Philippe Bouchaud, 2011. "Panel Statement: The endogenous dynamics of markets: price impact and feedback loops," Chapters, European Central Bank.
  8. Szabolcs Mike & J. Doyne Farmer, 2007. "An empirical behavioral model of liquidity and volatility," Papers 0709.0159, arXiv.org.
  9. Damian Eduardo Taranto & Giacomo Bormetti & Fabrizio Lillo, 2014. "The adaptive nature of liquidity taking in limit order books," Papers 1403.0842, arXiv.org, revised Apr 2014.
  10. Wang, Yougui & Stanley, H.E., 2009. "Statistical approach to partial equilibrium analysis," Physica A: Statistical Mechanics and its Applications, Elsevier, vol. 388(7), pages 1173-1180.

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