Exact Solution to a Generalised Lillo–Mike–Farmer Model with Heterogeneous Order-Splitting Strategies

Abstract

The Lillo–Mike–Farmer (LMF) model is an established econophysics model describing the order-splitting behaviour of institutional investors in financial markets. In the original article (Lillo et al. in Phys Rev E 71:066122, 2005), LMF assumed the homogeneity of the traders’ order-splitting strategy and derived a power-law asymptotic solution to the order-sign autocorrelation function (ACF) based on several heuristic reasonings. This report proposes a generalised LMF model by incorporating the heterogeneity of traders’ order-splitting behaviour that is exactly solved without heuristics. We find that the power-law exponent in the order-sign ACF is robust for arbitrary heterogeneous order-submission probability distributions. On the other hand, the prefactor in the ACF is very sensitive to heterogeneity in trading strategies and is shown to be systematically underestimated in the original homogeneous LMF model. Our work highlights that predicting the ACF prefactor is more challenging than the ACF exponent because many microscopic details (complex ingredients in actual data analyses) start to matter.