An empirical behavioral model of liquidity and volatility

TL;DR

This paper presents an empirical behavioral model of liquidity and volatility based on real trading order flow data from the London Stock Exchange, successfully predicting certain market microstructure effects for specific stock groups.

Contribution

It introduces a validated agent-based model of order flow that captures key empirical regularities and explains volatility and spread distributions for low-volatility, small-tick stocks.

Findings

Model accurately predicts volatility and spread distributions for Group I stocks.

Model's predictions align with real data without parameter tuning for these stocks.

Heavy tails of price returns are linked to market microstructure effects.

Abstract

We develop a behavioral model for liquidity and volatility based on empirical regularities in trading order flow in the London Stock Exchange. This can be viewed as a very simple agent based model in which all components of the model are validated against real data. Our empirical studies of order flow uncover several interesting regularities in the way trading orders are placed and cancelled. The resulting simple model of order flow is used to simulate price formation under a continuous double auction, and the statistical properties of the resulting simulated sequence of prices are compared to those of real data. The model is constructed using one stock (AZN) and tested on 24 other stocks. For low volatility, small tick size stocks (called Group I) the predictions are very good, but for stocks outside Group I they are not good. For Group I, the model predicts the correct magnitude and functional form of the distribution of the volatility and the bid-ask spread, without adjusting any parameters based on prices. This suggests that at least for Group I stocks, the volatility and heavy tails of prices are related to market microstructure effects, and supports the hypothesis that, at least on short time scales, the large fluctuations of absolute returns are well described by a power law with an exponent that varies from stock to stock.