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A quantitative model of trading and price formation in financial markets

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

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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Paper provided by in its series 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. Hausman, Jerry A. & Lo, Andrew W. & MacKinlay, Archie Craig, 1955-, 1990. "An ordered probit analysis of transaction stock prices," Working papers 3234-90., Massachusetts Institute of Technology (MIT), Sloan School of Management.
  2. Bollerslev, Tim & Domowitz, Ian & Wang, Jianxin, 1997. "Order flow and the bid-ask spread: An empirical probability model of screen-based trading," Journal of Economic Dynamics and Control, Elsevier, vol. 21(8-9), pages 1471-1491, June.
  3. Carl Chiarella & Giulia Iori, 2002. "A simulation analysis of the microstructure of double auction markets," Quantitative Finance, Taylor & Francis Journals, vol. 2(5), pages 346-353.
  4. Damien Challet & Robin Stinchcombe, 2001. "Analyzing and modelling 1+1d markets," Papers cond-mat/0106114,, revised Jun 2001.
  5. Vasiliki Plerou & Parameswaran Gopikrishnan & Xavier Gabaix & H. Eugene Stanley, 2001. "Quantifying Stock Price Response to Demand Fluctuations," Papers cond-mat/0106657,
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