Reconciling Market Efficiency with the Long-Memory of Supply and Demand

Farmer, Doyne, Gerig, Austin, Lillo, Fabrizio and Mike, Szabolcs (2006) Reconciling Market Efficiency with the Long-Memory of Supply and Demand. In: Annual American Physical Society Meeting, March, 2006, Baltimore, Maryland. (Unpublished)

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Abstract

In this comment we discuss the problem of reconciling the linear efficiency of price returns with the long-memory of supply and demand. We present new evidence that shows that efficiency is maintained by a liquidity imbalance that co-moves with the imbalance of buyer vs. seller initiated transactions. For example, during a period where there is an excess of buyer initiated transactions, there is also more liquidity for buy orders than sell orders, so that buy orders generate smaller and less frequent price responses than sell orders. At the moment a buy order is placed the transaction sign imbalance tends to dominate, generating a price impact. However, the liquidity imbalance rapidly increases with time, so that after a small number of time steps it cancels all the inefficiency caused by the transaction sign imbalance, bounding the price impact. While the view presented by Bouchaud et al. of a fixed and temporary bare price impact is self-consistent and formally correct, we argue that viewing this in terms of a variable but permanent price impact provides a simpler and more
natural view. This is in the spirit of the original conjecture of Lillo and Farmer, but generalized to allow for finite time lags in the build up of the liquidity imbalance
after a transaction. We discuss the possible strategic motivations that give rise to the liquidity imbalance and offer an alternative hypothesis. We also present some results that call into question the statistical significance of large swings in expected price impact at long times.

Item Type: Conference or Workshop Item (Paper)
Keywords: Market Efficiency; Supply and Demand; Liquidity
Subject(s): Complexity
Centre: CABDyN Complexity Centre
Date Deposited: 05 Mar 2012 20:04
Last Modified: 23 Oct 2015 14:07
URI: http://eureka.sbs.ox.ac.uk/id/eprint/2740

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