A quantitative model of trading and price formation in financial markets

Details A quantitative model of trading and price formation in financial markets A quantitative model of trading and price formation in financial markets

2001-12-23

arxiv.org/abs/cond-mat/0112422v6

Physics

Condensed Matter

Statistical Mechanics

5 pages, 4 figures

Scientific paper

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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