Quantitative Model of Price Diffusion and Market Friction Based on Trading as a Mechanistic Random Process

Posted: 8 Nov 2005

See all articles by Giulia Iori

Giulia Iori

City University London - Department of Economics

J. Doyne Farmer

University of Oxford - Institute for New Economic Thinking at the Oxford Martin School; Santa Fe Institute

Eric Smith

Santa Fe Institute - Economics

Laszlo Gillemot

Santa Fe Institute; Budapest University of Technology and Economics

Abstract

We model trading and price formation in a market under the assumption that order arrival and cancellations are Poisson random processes. This model makes testable predictions for the most basic properties of markets, such as the diffusion rate of prices (which is the standard measure of financial risk) and the spread and price impact functions (which are the main determinants of transaction cost). Guided by dimensional analysis, simulation, and mean-field theory, we find scaling relations in terms of order flow rates. We show that even under completely random order flow the need to store supply and demand to facilitate trading induces anomalous diffusion and temporal structure in prices.

JEL Classification: G12, C63

Suggested Citation

Iori, Giulia and Farmer, J. Doyne and Smith, David Eric and Gillemot, Laszlo, Quantitative Model of Price Diffusion and Market Friction Based on Trading as a Mechanistic Random Process. Physical Review Letters, Vol. 90, No. 10, 2003. Available at SSRN: https://ssrn.com/abstract=841527

Giulia Iori

City University London - Department of Economics ( email )

Northampton Square
London, EC1V 0HB
United Kingdom

J. Doyne Farmer (Contact Author)

University of Oxford - Institute for New Economic Thinking at the Oxford Martin School ( 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/

David Eric Smith

Santa Fe Institute - Economics ( email )

1399 Hyde Park Rd
Santa Fe, NM 87501
United States

Laszlo Gillemot

Santa Fe Institute ( email )

1399 Hyde Park Road
Santa Fe, NM 87501
United States

Budapest University of Technology and Economics ( email )

Muegyetem rkp. 3-9
H-1111 Budapest
Hungary

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