Mechanical vs. informational components of price impact
- 123 Downloads
We study the problem of what causes prices to change. It is well known that trading impacts prices — orders to buy drive the price up, and orders to sell drive it down. We introduce a means of decomposing the total impact of trading into two components, defining the mechanical impact of a trading order as the change in future prices in the absence of any future changes in decision making, and the informational impact as the remainder of the total impact once mechanical impact is removed. This decomposition is performed using order book data from the London Stock Exchange. The average mechanical impact of a market order decays to zero as a function of time, at an asymptotic rate that is consistent with a power law with an exponent of roughly 1.7. In contrast the average informational impact builds to approach a constant value. Initially the impact is entirely mechanical, and is about half as big as the asymptotic informational impact. The size of the informational impact is positively correlated to mechanical impact. For cases where the mechanical impact is zero for all times, we find that the informational impact is negative, i.e. buy market orders that have no mechanical impact at all generate strong negative price responses.
PACS.89.65.Gh Economics; econophysics, financial markets, business and management
Unable to display preview. Download preview PDF.
- D.M. Cutler, J.M. Poterba, L.H. Summers, J. of Portfolio Management 15, 4 (1989) Google Scholar
- J.D. Farmer, Slippage 1996, Technical report (Prediction Company, 1996) Google Scholar
- N. Torre, BARRA Market Impact Model Handbook (BARRA Inc., Berkeley, 1997) Google Scholar
- V. Plerou, P. Gopikrishnan, X. Gabaix, H.E. Stanley, Phys. Rev. E 66, article No. 027104, (2002) Google Scholar
- C. Hopman, Are supply an demand driving stock prices? MIT working paper, Dec. 2002, to appear in Quantitative Finance Google Scholar
- F. Lillo, R.N. Mantegna, Phys. Rev. E 68, 2003, Part 2 Google Scholar
- M. Wyart, J.-P. Bouchaud, J. Kockelkoren, M. Potters, M. Vettorazzo, Technical Report, 2006 Google Scholar
- S.J. Grossman, J.E. Stiglitz, Am. Economic Rev. 70, 393 (1980) Google Scholar
- S.J. Grossman The Informational Role of Prices (MIT Press, Cambridge, 1989) Google Scholar
- S. Mike, J.D. Farmer, J. of Economic Dynamics and Control (2006), to appear Google Scholar
- Vaglica, F. Lillo, E. Moro, R. Mantegna, unpublished work, (2006) Google Scholar