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Dynamic Equilibrium and Volatility in Financial Asset Markets

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  • YACINE AÏT-SAHALIA

Abstract

This paper develops and estimates a continuous-time model of a financial market where investors' trading strategies and the specialist's rule of price adjustments are the best response to each other. We examine how far modeling market microstructure in a purely rational framework can go in explaining alleged asset pricing `anomalies.' The model produces some major findings of the empirical literature: excess volatility of the market price compared to the asset's fundamental value, serially correlated volatility, contemporaneous volume-volatility correlation, and excess kurtosis of price changes. We implement a nonlinear filter to estimate the unobservable fundamental value, and avoid the discretization bias by computing the exact conditional moments of the price and volume processes over time intervals of any length.

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Paper provided by Center for Research in Security Prices, Graduate School of Business, University of Chicago in its series CRSP working papers with number 331.

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Handle: RePEc:wop:chispw:331

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  1. John Y. Campbell & Albert S. Kyle, 1988. "Smart Money, Noise Trading and Stock Price Behavior," NBER Technical Working Papers 0071, National Bureau of Economic Research, Inc.
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  4. Christie, William G & Harris, Jeffrey H & Schultz, Paul H, 1994. " Why Did NASDAQ Market Makers Stop Avoiding Odd-Eighth Quotes?," Journal of Finance, American Finance Association, American Finance Association, vol. 49(5), pages 1841-60, December.
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  6. Grossman, Sanford J & Miller, Merton H, 1988. " Liquidity and Market Structure," Journal of Finance, American Finance Association, American Finance Association, vol. 43(3), pages 617-37, July.
  7. Detemple, Jerome B, 1986. " Asset Pricing in a Production Economy with Incomplete Information," Journal of Finance, American Finance Association, American Finance Association, vol. 41(2), pages 383-91, June.
  8. Campbell, John Y & Grossman, Sanford J & Wang, Jiang, 1993. "Trading Volume and Serial Correlation in Stock Returns," The Quarterly Journal of Economics, MIT Press, MIT Press, vol. 108(4), pages 905-39, November.
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  25. Tauchen, George E & Pitts, Mark, 1983. "The Price Variability-Volume Relationship on Speculative Markets," Econometrica, Econometric Society, Econometric Society, vol. 51(2), pages 485-505, March.
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  29. Lee, Charles M C & Ready, Mark J, 1991. " Inferring Trade Direction from Intraday Data," Journal of Finance, American Finance Association, American Finance Association, vol. 46(2), pages 733-46, June.
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Cited by:
  1. Frank Gerhard & Dieter Hess & Winfried Pohlmeier, 1999. "What a Difference a Day Makes: On the Common Market Microstructure of Trading Days," Finance, EconWPA 9904006, EconWPA.
  2. J. Q. Smith & António Santos, 2005. "Second Order Filter Distribution Approximations for Financial Time Series with Extreme Outliers," GEMF Working Papers 2005-11, GEMF - Faculdade de Economia, Universidade de Coimbra.

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