Theory for long memory in supply and demand.
Recent empirical studies have demonstrated long-memory in the signs of orders to buy or sell in financial markets [J.-P. Bouchaud, Y. Gefen, M. Potters, and M. Wyart, Quant. Finance 4, 176 (2004); F. Lillo and J. D. Farmer Dyn. Syst. Appl. 8, 3 (2004)]. We show how this can be caused by delays in market clearing. Under the common practice of order splitting, large orders are broken up into pieces and executed incrementally. If the size of such large orders is power-law distributed, this gives rise to power-law decaying autocorrelations in the signs of executed orders. More specifically, we show that if the cumulative distribution of large orders of volume v is proportional to v(-alpha) and the size of executed orders is constant, the autocorrelation of order signs as a function of the lag tau is asymptotically proportional to tau(-(alpha-1)). This is a long-memory process when alpha < 2. With a few caveats, this gives a good match to the data. A version of the model also shows long-memory fluctuations in order execution rates, which may be relevant for explaining the long memory of price diffusion rates.
Lillo
Fabrizio
F
Santa Fe Institute, 1399 Hyde Park Road, Santa Fe, New Mexico 87501, USA.
Mike
Szabolcs
S
Farmer
J Doyne
JD