A Theory of Price Formation in Financial Markets

35 Pages Posted: 7 Mar 2023

See all articles by Emanuele Guidotti

Emanuele Guidotti

University of Neuchâtel - Institute of Financial Analysis

Date Written: March 3, 2023

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.

Suggested Citation

Guidotti, Emanuele, A Theory of Price Formation in Financial Markets (March 3, 2023). Available at SSRN: https://ssrn.com/abstract=4377151 or http://dx.doi.org/10.2139/ssrn.4377151

Emanuele Guidotti (Contact Author)

University of Neuchâtel - Institute of Financial Analysis ( email )

Rue Abram-Louis-Breguet 2
Neuchâtel, 2000
Switzerland

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