Linear Models for the Impact of Order Flow on Prices I. Propagators: Transient vs. History Dependent Impact

22 Pages Posted: 28 Apr 2016

See all articles by Damian Taranto

Damian Taranto

Scuola Normale Superiore

Giacomo Bormetti

University of Bologna - Department of Mathematics

Jean-Philippe Bouchaud

Capital Fund Management

Fabrizio Lillo

Università di Bologna

Bence Toth

Santa Fe Institute

Date Written: February 8, 2016

Abstract

Market impact is a key concept in the study of financial markets and several models have been proposed in the literature so far. The Transient Impact Model (TIM) posits that the price at high frequency time scales is a linear combination of the signs of the past executed market orders, weighted by a so-called propagator function. An alternative description -- the History Dependent Impact Model (HDIM) -- assumes that the deviation between the realised order sign and its expected level impacts the price linearly and permanently. The two models, however, should be extended since prices are a priori influenced not only by the past order flow, but also by the past realisation of returns themselves. In this paper, we propose a two-event framework, where price-changing and non price-changing events are considered separately. Two-event propagator models provide a remarkable improvement of the description of the market impact, especially for large tick stocks, where the events of price changes are very rare and very informative. Specifically the extended approach captures the excess anti-correlation between past returns and subsequent order flow which is missing in one-event models. Our results document the superior performances of the HDIMs even though only in minor relative terms compared to TIMs. This is somewhat surprising, because HDIMs are well grounded theoretically, while TIMs are, strictly speaking, inconsistent.

Keywords: Financial markets, market microstructure, market impact, liquidity

JEL Classification: C1, G1

Suggested Citation

Taranto, Damian and Bormetti, Giacomo and Bouchaud, Jean-Philippe and Lillo, Fabrizio and Toth, Bence, Linear Models for the Impact of Order Flow on Prices I. Propagators: Transient vs. History Dependent Impact (February 8, 2016). Available at SSRN: https://ssrn.com/abstract=2770352 or http://dx.doi.org/10.2139/ssrn.2770352

Damian Taranto (Contact Author)

Scuola Normale Superiore ( email )

Piazza dei Cavalieri, 7
Pisa, 56126
Italy

Giacomo Bormetti

University of Bologna - Department of Mathematics ( email )

Piazza di Porta S. Donato , 5
Bologna, Bologna 40126
Italy

Jean-Philippe Bouchaud

Capital Fund Management ( email )

23 rue de l'Université
Paris, 75007
France
+33 1 49 49 59 20 (Phone)

Fabrizio Lillo

Università di Bologna ( email )

Via Zamboni, 33
Bologna, 40126
Italy

Bence Toth

Santa Fe Institute ( email )

1399 Hyde Park Road
Santa Fe, NM 87501
United States

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