Demand Storage, Market Liquidity, and Price Volatility

Book : Scholarly edition

The limit order book is a device for storing demand and effecting trades that is the primary mechanism for price formation in most modern financial markets. We study the limit order book under a random process model of order flow, using simulations and an analytic treatment based on a master equation. We make testable predictions of the price diffusion rate, the depth of stored demand vs. price, the bid-ask spread, and the price impact. Our model provides an explanation for the empirically observed concave form of the price impact function.

Authors: Daniels, MG; Farmer, J; Iori, G; Smith, E

• Keywords: volatility; limit orders; price formation; Financial markets; dimensional analysis; master equation; random process; liquidity
• Subtype: Scholarly edition