Market Microstructure Invariance: A Dynamic Equilibrium Model

Albert Kyle () and Anna Obizhaeva ()
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Albert Kyle: University of Maryland
Anna Obizhaeva: New Economic School

No w0267, Working Papers from New Economic School (NES)

Abstract: We derive invariance relationships in a dynamic, infinite-horizon, equilibrium model of adverse selection with risk-neutral informed traders, noise traders, market makers, and with endogenous information production. Scaling laws for bet size and transaction costs require the assumption that the effort required to generate one bet does not vary across securities and time. Scaling laws for pricing accuracy and market resiliency require the additional assumption that private information has the same signal-to-noise ratio across markets. Prices follow a martingale with endogenously derived stochastic volatility. Returns volatility, pricing accuracy, liquidity, and market resiliency are connected by a specific proportionality relationship. The model solution depends on two state variables: stock price and hard-to-observe pricing accuracy. Invariance makes predictions operational by expressing them in terms of log-linear functions of easily observable variables such as price, volume, and volatility.

Keywords: Market microstructure; invariance; liquidity; bid-ask spread; market impact; transaction costs; market efficiency; efficient markets hypothesis; pricing accuracy; resiliency; order size. (search for similar items in EconPapers)
Pages: 59 pages
Date: 2020-07
New Economics Papers: this item is included in nep-mst
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Citations: View citations in EconPapers (2)

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