Modelling Price Pressure in Financial Markets
26 Pages Posted: 3 Jun 2004
Date Written: August 2003
We present experimental evidence that security prices do not respond to pressure from their own excess demand, unlike traditionally assumed in economic theory. Instead, prices respond to excess demand of all securities, despite the absence of a direct link between markets. We propose a model of price pressure that explains these findings. In our model, agents set order prices that reflect the marginal valuation of desired future holdings, called aspiration levels.
In the short run, as agents encounter difficulties executing their orders, they scale back their aspiration levels. Marginal valuations, order prices, and hence, transaction prices change correspondingly.
Our model makes a specific prediction about the nature of cross-security effects: the covariance between a security's transaction price and another security's excess demand will be proportional to the corresponding covariance. This additional prediction is fully borne out by the data.
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