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Demand Storage, Market Liquidity, and Price Volatility

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

The limit order book is a device for storing demand and effecting trades that is the primary mechanism for price formation in most modern financial markets. We study the limit order book under a random process model of order flow, using simulations and an analytic treatment based on a master equation. We make testable predictions of the price diffusion rate, the depth of stored demand vs. price, the bid-ask spread, and the price impact. Our model provides an explanation for the empirically observed concave form of the price impact function.

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Paper provided by Santa Fe Institute in its series Working Papers with number 02-01-001.

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Date of creation: Jan 2002
Date of revision:
Handle: RePEc:wop:safiwp:02-01-001
Contact details of provider: Postal: 1399 Hyde Park Road, Santa Fe, New Mexico 87501
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  1. J. Doyne Farmer, 1998. "Market Force, Ecology, and Evolution," Research in Economics 98-12-117e, Santa Fe Institute.
  2. 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.
  3. Challet, Damien & Stinchcombe, Robin, 2001. "Analyzing and modeling 1+1d markets," Physica A: Statistical Mechanics and its Applications, Elsevier, vol. 300(1), pages 285-299.
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