How Markets Slowly Digest Changes in Supply and Demand

Abstract

Publisher Summary This chapter discusses the new approach to the classic problem of tâtonnement —the dynamic process through which markets seek to reach equilibrium. The foundation of this approach is based on several empirical observations about financial markets. The most important of which is long memory in the fluctuations of supply and demand. This is exhibited in the placement of trading orders and corresponds to long-term, slowly decaying positive correlations in the initiation of buying versus selling. It is observed in all the stock markets studied so far at very high levels of statistical significance. It appears that the primary cause of this long memory is the incremental execution of large hidden trading orders. The fact that the long memory of order flow must coexist with market efficiency has a profound influence on price formation, causing dynamic adjustments of liquidity that are strongly asymmetric between buyers and sellers. This has important consequences for market impact. This work has also important consequences about the interpretation and effect of information in financial markets. In particular, the explanation for market impact is that the shape of the impact function is determined by differences in the information content of trades.