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Modelling price pressure in financial markets

  • Asparouhova, Elena
  • Bossaerts, Peter
Registered author(s):

    We present experimental evidence that, unlike traditional assumptions in economic theory, security prices do not respond to pressure from their own excess demand. Instead, prices respond to excess demand of all securities, despite the absence of a direct link between markets. We propose a model of price pressure that explains these findings. In our model, agents set order prices that reflect the marginal valuation of desired future holdings, called "aspiration levels." In the short run, as agents encounter difficulties executing their orders, they scale back their aspiration levels. Marginal valuations, order prices, and hence, transaction prices change correspondingly. The resulting price adjustment process coincides with the Global Newton Method. The assumptions of the model as well as its empirical implications are fully borne out by the data. Our model thus provides an economic foundation for why markets appear to search for equilibrium according to Newton's procedure.

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    File URL: http://www.sciencedirect.com/science/article/B6V8F-4VV2NF2-4/2/687d05bb710c9b6df6ede1589bbc039f
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    Article provided by Elsevier in its journal Journal of Economic Behavior & Organization.

    Volume (Year): 72 (2009)
    Issue (Month): 1 (October)
    Pages: 119-130

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    Handle: RePEc:eee:jeborg:v:72:y:2009:i:1:p:119-130
    Contact details of provider: Web page: http://www.elsevier.com/locate/jebo

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    1. Kalay, Avner & Wohl, Avi, 2009. "Detecting Liquidity Traders," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 44(01), pages 29-54, February.
    2. Peter Bossaerts & William R. Zame, 2006. "Risk Aversion in Laboratory Asset Markets," Levine's Bibliography 122247000000001317, UCLA Department of Economics.
    3. Smale, Stephen, 1976. "Exchange processes with price adjustment," Journal of Mathematical Economics, Elsevier, vol. 3(3), pages 211-226, December.
    4. Asparouhova, Elena & Bossaerts, Peter & Plott, Charles, 2003. "Excess demand and equilibration in multi-security financial markets: the empirical evidence," Journal of Financial Markets, Elsevier, vol. 6(1), pages 1-21, January.
    5. John O. Ledyard, 1974. "Decentralized Disequilibrium Trading and Price Formation," Discussion Papers 86, Northwestern University, Center for Mathematical Studies in Economics and Management Science.
    6. Charles A. Holt & Susan K. Laury, 2002. "Risk Aversion and Incentive Effects," American Economic Review, American Economic Association, vol. 92(5), pages 1644-1655, December.
    7. Bossaerts, Peter & Plott, Charles R., 2000. "Basic Principles of Asset Pricing Theory: Evidence From Large-Scale Experimental Financial Markets," Working Papers 1070, California Institute of Technology, Division of the Humanities and Social Sciences.
    8. Peter Bossaerts & Charles Plott & William R. Zame, 2007. "Prices and Portfolio Choices in Financial Markets: Theory, Econometrics, Experiments," Econometrica, Econometric Society, vol. 75(4), pages 993-1038, 07.
    9. Smale, Steve, 1976. "A convergent process of price adjustment and global newton methods," Journal of Mathematical Economics, Elsevier, vol. 3(2), pages 107-120, July.
    10. Saari, Donald G & Simon, Carl P, 1978. "Effective Price Mechanisms," Econometrica, Econometric Society, vol. 46(5), pages 1097-1125, September.
    11. Gode, Dhananjay K & Sunder, Shyam, 1993. "Allocative Efficiency of Markets with Zero-Intelligence Traders: Market as a Partial Substitute for Individual Rationality," Journal of Political Economy, University of Chicago Press, vol. 101(1), pages 119-37, February.
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