The drift burst hypothesis

TL;DR

This paper introduces the drift burst hypothesis, modeling short-lived explosive trends in financial prices, and develops a test to detect these bursts, revealing their frequent occurrence across various asset classes and their association with flash crashes.

Contribution

It formalizes the concept of drift bursts within continuous-time models and provides a nonparametric test to identify them in high-frequency data, demonstrating their prevalence in financial markets.

Findings

Drift bursts occur weekly on average across asset classes.

Most drift bursts are followed by price reversions, akin to flash crashes.

Negative drift bursts with high volume show stronger reversions.

Abstract

The drift burst hypothesis postulates the existence of short-lived locally explosive trends in the price paths of financial assets. The recent U.S. equity and treasury flash crashes can be viewed as two high-profile manifestations of such dynamics, but we argue that drift bursts of varying magnitude are an expected and regular occurrence in financial markets that can arise through established mechanisms of liquidity provision. We show how to build drift bursts into the continuous-time It\^o semimartingale model, elaborate on the conditions required for the process to remain arbitrage-free, and propose a nonparametric test statistic that identifies drift bursts from noisy high-frequency data. We apply the test and demonstrate that drift bursts are a stylized fact of the price dynamics across equities, fixed income, currencies and commodities. Drift bursts occur once a week on average, and the majority of them are accompanied by subsequent price reversion and can thus be regarded as "flash crashes." The reversal is found to be stronger for negative drift bursts with large trading volume, which is consistent with endogenous demand for immediacy during market crashes.