Demand Storage, Market Liquidity, and Price Volatility

Marcus G. Daniels, J. Farmer, Giulia Iori and Eric Smith

Working Papers from Santa Fe Institute

Abstract: The limit order book is a device for storing demand and effecting trades that is the primary mechanism for price formation in most modern financial markets. We study the limit order book under a random process model of order flow, using simulations and an analytic treatment based on a master equation. We make testable predictions of the price diffusion rate, the depth of stored demand vs. price, the bid-ask spread, and the price impact. Our model provides an explanation for the empirically observed concave form of the price impact function.

Keywords: Financial markets; price formation; volatility; liquidity; master equation; random process; limit orders; dimensional analysis (search for similar items in EconPapers)
Date: 2002-01
New Economics Papers: this item is included in nep-fmk and nep-mic
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Persistent link: https://EconPapers.repec.org/RePEc:wop:safiwp:02-01-001

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