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Demand Storage, Market Liquidity, and Price Volatility

Author

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

Abstract

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.

Suggested Citation

  • Marcus G. Daniels & J. Doyne Farmer & Giulia Iori & Eric Smith, 2002. "Demand Storage, Market Liquidity, and Price Volatility," Working Papers 02-01-001, Santa Fe Institute.
  • Handle: RePEc:wop:safiwp:02-01-001
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    References listed on IDEAS

    as
    1. J. Doyne Farmer, 2002. "Market force, ecology and evolution," Industrial and Corporate Change, Oxford University Press, vol. 11(5), pages 895-953, November.
    2. 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.
    3. 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 119-137, February.
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    More about this item

    Keywords

    Financial markets; price formation; volatility; liquidity; master equation; random process; limit orders; dimensional analysis;

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