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What really causes large price changes?

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Author Info
J. Doyne Farmer
Laszlo Gillemot
Fabrizio Lillo
Szabolcs Mike
Anindya Sen
Abstract

We study the cause of large fluctuations in prices in the London Stock Exchange. This is done at the microscopic level of individual events, where an event is the placement or cancellation of an order to buy or sell. We show that price fluctuations caused by individual market orders are essentially independent of the volume of orders. Instead, large price fluctuations are driven by liquidity fluctuations, variations in the market's ability to absorb new orders. Even for the most liquid stocks there can be substantial gaps in the order book, corresponding to a block of adjacent price levels containing no quotes. When such a gap exists next to the best price, a new order can remove the best quote, triggering a large midpoint price change. Thus, the distribution of large price changes merely reflects the distribution of gaps in the limit order book. This is a finite size effect, caused by the granularity of order flow: In a market where participants placed many small orders uniformly across prices, such large price fluctuations would not happen. We show that this explains price fluctuations on longer timescales. In addition, we present results suggesting that the risk profile varies from stock to stock, and is not universal: lightly traded stocks tend to have more extreme risks.

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File URL: http://arxiv.org/abs/cond-mat/0312703
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Paper provided by arXiv.org in its series Quantitative Finance Papers with number cond-mat/0312703.

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Date of creation: Dec 2003
Date of revision: Apr 2004
Handle: RePEc:arx:papers:cond-mat/0312703

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  1. Louis R. Mercorelli & David Michayluk & Anthony D. Hall, 2008. "Modelling Adverse Selection on Electronic Order-Driven Markets," Research Paper Series 220, Quantitative Finance Research Centre, University of Technology, Sydney. [Downloadable!]
  2. Mardi Dungey & Charles Goodhart & Demosthenes Tambakis, 2005. "The Us Treasury Market In August 1998: Untangling The Effects Og Hong Kong And Russia With High Frequency Data," CAMA Working Papers 2005-25, Australian National University, Centre for Applied Macroeconomic Analysis. [Downloadable!]
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  3. Carl Chiarella & Roberto Dieci & Xue-Zhong He, 2009. "A Framework for CAPM with Heterogenous Beliefs," Research Paper Series 254, Quantitative Finance Research Centre, University of Technology, Sydney. [Downloadable!]
  4. Ádám G. Zawadowski & György Andor & János Kertész, 2006. "Short-term market reaction after extreme price changes of liquid stocks," Quantitative Finance, Taylor and Francis Journals, vol. 6(4), pages 283-295, August. [Downloadable!] (restricted)
  5. Jean-Philippe Bouchaud & Julien Kockelkoren & Marc Potters, 2006. "Random walks, liquidity molasses and critical response in financial markets," Quantitative Finance, Taylor and Francis Journals, vol. 6(2), pages 115-123, April. [Downloadable!] (restricted)
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  6. Matthieu Wyart & Jean-Philippe Bouchaud & Julien Kockelkoren & Marc Potters & Michele Vettorazzo, 2006. "Relation between Bid-Ask Spread, Impact and Volatility in Double Auction Markets," Science & Finance (CFM) working paper archive 500067, Science & Finance, Capital Fund Management. [Downloadable!]
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  7. Carl Chiarella & Giulia Iori & Josep Perello, 2007. "The Impact of Heterogeneous Trading Rules on the Limit Order Book and Order Flows," Quantitative Finance Papers 0711.3581, arXiv.org. [Downloadable!]
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