Semi-Markov Model for Market Microstructure

Pietro Fodra and Huyên Pham

Applied Mathematical Finance, 2015, vol. 22, issue 3, 261-295

Abstract: We introduce a new model based on Markov renewal processes (MRP) describing the fluctuations of a tick-by-tick single asset price. We consider a point process associated to the timestamps of the price jumps, with marks associated to price increments. By modelling the marks with a suitable Markov chain, we can reproduce the strong mean-reversion of price returns, a phenomenon known as microstructure noise. Moreover, using MRP, we can model the alternating of time intervals with high and low market activity, and consider dependence between price increments and jump times. We also provide simple parametric and nonparametric statistical procedures for the estimation of our model. We obtain closed-form formula for the mean signature plot, and show the diffusive behaviour of our model at large-scale limit. We illustrate our results by numerical simulations, and find that our model is consistent with available empirical data.

Date: 2015
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DOI: 10.1080/1350486X.2015.1037963

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