The Inelastic Market Hypothesis: A Microstructural Interpretation

TL;DR

This paper integrates the Inelastic Market Hypothesis with microstructure theory, showing that price impacts and volatility are primarily driven by order flow, with implications across asset classes.

Contribution

It provides a microstructural interpretation of the IMH, deriving predictions for the market impact multiplier and extending the hypothesis beyond stock markets.

Findings

Market impact multiplier M is of order unity.

M increases with stock volatility.

Most volatility is due to trading activity.

Abstract

We attempt to reconcile Gabaix and Koijen's (GK) recent Inelastic Market Hypothesis (IMH) with the order-driven view of markets that emerged within the microstructure literature in the past 20 years. We review the most salient empirical facts and arguments that give credence to the idea that market price fluctuations are mostly due to order flow, whether informed or non-informed. We show that the Latent Liquidity Theory of price impact makes a precise prediction for GK's multiplier $M$, which measures by how many dollars, on average, the market value of a company goes up if one buys one dollar worth of its stocks. Our central result is that $M$ is of order unity, as found by GK, and increases with the volatility of the stock and decreases with the fraction of the market cap. traded daily. We discuss several empirical results suggesting that the lion's share of volatility is due to trading activity. We argue that the IMH holds for all asset classes, beyond the case of stock markets considered by GK.