An Empirical Behavioral Model of Liquidity and Volatility

35 Pages Posted: 1 Oct 2005

See all articles by Szabolcs Mike

Szabolcs Mike

Santa Fe Institute - Economics; Budapest University of Technology and Economics

J. Doyne Farmer

University of Oxford - Institute for New Economic Thinking at the Oxford Martin School; Santa Fe Institute

Abstract

We develop a behavioral model for liquidity and volatility based on empirical regularities in trading order flow in the London Stock Exchange. This can be viewed as a very simple agent based model in which all components of the model are validated against real data. Our empirical studies of order flow uncover several interesting regularities in the way trading orders are placed and cancelled. The resulting simple model of order flow is used to simulate price formation under a continuous double auction, and the statistical properties of the resulting simulated sequence of prices are compared to those of real data. The model is constructed using one stock (AZN) and tested on 24 other stocks. For low volatility, small tick size stocks (called Group I) the predictions are very good, but for stocks outside Group I they are not good. For Group I, the model predicts the correct magnitude and functional form of the distribution of the volatility and the bid-ask spread, without adjusting any parameters based on prices. This suggests that at least for Group I stocks, the volatility and heavy tails of prices are related to market microstructure effects, and supports the hypothesis that, at least on short time scales, the large fluctuations of absolute returns are well described by a power law with an exponent that varies from stock to stock.

Keywords: Behavioral economics, financial market, order placement, cancellation model, price formation

Suggested Citation

Mike, Szabolcs and Farmer, J. Doyne, An Empirical Behavioral Model of Liquidity and Volatility. Journal of Economic Dynamics and Control, Forthcoming. Available at SSRN: https://ssrn.com/abstract=1011403

Szabolcs Mike

Santa Fe Institute - Economics ( email )

1399 Hyde Park Rd
Santa Fe, NM 87501
United States

Budapest University of Technology and Economics ( email )

Muegyetem rkp. 3-9
H-1111 Budapest
Hungary

J. Doyne Farmer (Contact Author)

University of Oxford - Institute for New Economic Thinking at the Oxford Martin School ( email )

Eagle House
Walton Well Road
Oxford, OX2 6ED
United Kingdom

HOME PAGE: http://www.inet.ox.ac.uk/people/view/4

Santa Fe Institute ( email )

1399 Hyde Park Road
Santa Fe, NM 87501
United States
505-984-8800 (Phone)
505-982-0565 (Fax)

HOME PAGE: http://www.santafe.edu/~jdf/

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