A Bayesian viewpoint on the price formation process

TL;DR

This paper presents a Bayesian framework for understanding price formation, modeling how market participants update their beliefs and how this influences order arrivals and market impact, especially with Brownian efficient prices.

Contribution

It introduces a Bayesian approach to model market dynamics and order arrivals, connecting belief updates with market impact and order flow in a novel way.

Findings

Exponential intensities for aggressive order arrivals naturally emerge from the model.

The framework describes market dynamics with Brownian efficient prices and informed traders.

Revisits market impact due to meta-order splitting within a Bayesian context.

Abstract

We introduce a simple framework in which market participants update their prior about an efficient price with a model-based learning process. We show that exponential intensities for the arrival of aggressive orders arise naturally in this setting. Our approach allows us to fully describe market dynamics in the case with Brownian efficient price and informed market takers. We are also able to revisit the emergence of market impact due to meta-order splitting, making several connections with existing literature.