Abstract
The design of this study is to investigate the evolution of a stochastic price process consequent to discrete processes of bids and offers in a market microstructure setting. Under a set of flexible assumptions about agent preferences, we generate a price process to compare with observation. Specifically, we allow for both rational and irrational economic behavior, abstracting the inquiry from classical studies relying on utility theory. The goal is to provide a set of economic primitives which point inexorably to the price processes we see, rather than to assume such process from the start.
Highlights
IntroductionWe propose to model a price process based on microstructural activity of a market. We assume a set of agents such that each agent at any moment has both bid and ask prices present in the market
The design of this study is to investigate the evolution of a stochastic price process consequent to discrete processes of bids and offers in a market microstructure setting
We propose to model a price process based on microstructural activity of a market
Summary
We propose to model a price process based on microstructural activity of a market. We assume a set of agents such that each agent at any moment has both bid and ask prices present in the market. In the former paper, Engle, in referring to cases of the conditional duration function, relates, “In each case, the density is assumed to be exponential.” Such assumptions are typical, and necessary, for an econometric study focusing on time series of prices as the fundamental data structure. In our paper we choose to move to a more basic level of explanation, to specify the market mechanisms among interacting agents, and to let the model determine the price process and its features In this way we derive such features as the distributions of prices, rather than assuming them ab initio.
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