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How Markets Slowly Digest Changes in Supply and Demand
[chapter]
<span title="">2009</span>
<i title="Elsevier">
Handbook of Financial Markets: Dynamics and Evolution
</i>
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In this article we revisit the classic problem of tatonnement, reviewing a recent body of theoretical and empirical work explaining how fluctuations in supply and demand are slowly incorporated into prices. For strategic reasons large orders to buy or sell are only traded incrementally, over periods of time that can be as long as months. Because of this fluctuations in supply and demand form a long-memory process, manifesting itself as highly persistent order flow. Liquidity dynamics plays a
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... role in determining volatility and in allowing the market to absorb large swings in supply and demand while remaining efficient. We review a body of theory that makes detailed quantitative predictions about the volume and time dependence of market impact, the bid ask spread, and order book dynamics, and show that the predictions of this body of theory compare well with empirical data. This approach suggests a novel interpretation of financial information, in which all agents are at best only weakly informed, price formation is extremely noisy, and most information comes from within rather than from outside the market. We review some preliminary studies of market ecology and argue that this should play a central role in the future.
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