A Theory of Price Formation in Financial Markets

Abstract

This paper presents a theory where prices are formed in a purely mechanical manner through trading. The theory consists of three fundamental propositions. First, the quantity exchanged in a trade equals the integrated density of the book between zero and the peak impact. Second, the peak impact relaxes to the permanent impact such that makers and takers earn zero profits in the transaction. Third, the asset price is determined by the accumulation of price impacts. The model is simple yet capable of replicating various patterns observed in financial data and reconciling disparate theoretical and empirical research strands.