Quantitative model of price diffusion and market friction based on trading as a mechanistic random process.
We 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 markets, 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.
Daniels
Marcus G
MG
Santa Fe Institute, 1399 Hyde Park Road, Santa Fe, New Mexico 87501, USA.
Farmer
J Doyne
JD
Gillemot
László
L
Iori
Giulia
G
Smith
Eric
E