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A quantitative model of trading and price formation in financial markets

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Author Info
Marcus G. Daniels
J. Doyne Farmer
Laszlo Gillemot
Giulia Iori
Eric Smith

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Abstract

We use standard physics techniques to model trading and price formation in a market under the assumption that order arrival and cancellations are Poisson random processes. This model makes testable predictions for the most basic properties of a market, such as the diffusion rate of prices, which is the standard measure of financial risk, and the spread and price impact functions, which are the main determinants of transaction cost. Guided by dimensional analysis, simulation, and mean field theory, we find scaling relations in terms of order flow rates. We show that even under completely random order flow the need to store supply and demand to facilitate trading induces anomalous diffusion and temporal structure in prices.

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File URL: http://arxiv.org/abs/cond-mat/0112422
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Paper provided by arXiv.org in its series Quantitative Finance Papers with number cond-mat/0112422.

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Date of creation: Dec 2001
Date of revision: Dec 2002
Handle: RePEc:arx:papers:cond-mat/0112422

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  1. Boer-Sorban, K. & Bruin, A. de & Kaymak, U., 2005. "On the Design of Artificial Stock Markets," Research Paper ERS-2005-001-LIS Revision, Erasmus Research Institute of Management (ERIM), ERIM is the joint research institute of the Rotterdam School of Management, Erasmus University and the Erasmus School of Economics (ESE) at Erasmus Uni. [Downloadable!]
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