The Predictive Power of Zero Intelligence in Financial Markets

18 Pages Posted: 11 Jan 2004  

J. Doyne Farmer

Institute for New Economic Thinking; Santa Fe Institute

Paolo Patelli

Santa Fe Institute

Ilija I. Zovko

affiliation not provided to SSRN

Date Written: February 9, 2004

Abstract

Standard models in economics stress the role of intelligent agents who maximize utility. However, there may be situations where, for some purposes, constraints imposed by market institutions dominate intelligent agent behavior. We use data from the London Stock Exchange to test a simple model in which zero intelligence agents place orders to trade at random. The model treats the statistical mechanics of order placement, price formation, and the accumulation of revealed supply and demand within the context of the continuous double auction, and yields simple laws relating order arrival rates to statistical properties of the market. We test the validity of these laws in explaining the cross-sectional variation for eleven stocks. The model explains 96% of the variance of the bid-ask spread, and 76% of the variance of the price diffusion rate, with only one free parameter. We also study the market impact function, describing the response of quoted prices to the arrival of new orders. The non-dimensional coordinates dictated by the model approximately collapse data from different stocks onto a single curve. This work is important from a practical point of view because it demonstrates the existence of simple laws relating prices to order flows, and in a broader context, because it suggests that there are circumstances where institutions are more important than strategic considerations.

Keywords: limit order book, limit orders, market microstructure, zero intelligence agents, agent based modeling

JEL Classification: G0, G1

Suggested Citation

Farmer, J. Doyne and Patelli, Paolo and Zovko, Ilija I., The Predictive Power of Zero Intelligence in Financial Markets (February 9, 2004). AFA 2004 San Diego Meetings. Available at SSRN: https://ssrn.com/abstract=483603 or http://dx.doi.org/10.2139/ssrn.483603

J. Doyne Farmer

Institute for New Economic Thinking ( 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/

Paolo Patelli

Santa Fe Institute ( email )

1399 Hyde Park Road
Santa Fe, NM 87501
United States

Ilija I. Zovko (Contact Author)

affiliation not provided to SSRN ( email )

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