Market Microstructure Invariance: A Dynamic Equilibrium Model

56 Pages Posted: 12 Feb 2019 Last revised: 31 Mar 2020

See all articles by Albert S. Kyle

Albert S. Kyle

University of Maryland

Anna A. Obizhaeva

New Economic School (NES)

Date Written: March 23, 2020

Abstract

We derive invariance relationships in a dynamic, infinite-horizon, equilibrium model of adverse selection with risk-neutral informed traders, noise traders, market makers, and with endogenous information production. The model solution depends on two state variables: stock price and hard-to-observe pricing accuracy (or liquidity). Invariance makes predictions operational by expressing them in terms of log-linear functions of easily observable variables such as price, volume, and volatility. Implied scaling laws for bet size and transaction costs require the assumption that the effort required to generate one bet does not vary across securities and time. Scaling laws for pricing errors and market resiliency require the additional assumption that private information has the same signal-to-noise ratio across markets. Prices follow a martingale with endogenously derived stochastic volatility. Returns volatility, pricing accuracy, liquidity, and market resiliency are connected by a specific log-linear relationship.

Keywords: Finance, financial economics, financial markets, market microstructure, liquidity, invariance, market impact, transaction costs, market efficiency, efficient markets hypothesis

JEL Classification: G10, G12, G14, G20

Suggested Citation

Kyle, Albert (Pete) S. and Obizhaeva, Anna A., Market Microstructure Invariance: A Dynamic Equilibrium Model (March 23, 2020). Available at SSRN: https://ssrn.com/abstract=3326889 or http://dx.doi.org/10.2139/ssrn.3326889

Albert (Pete) S. Kyle

University of Maryland ( email )

College Park
College Park, MD 20742
United States

Anna A. Obizhaeva (Contact Author)

New Economic School (NES) ( email )

100A Novaya ul
Moscow, Skolkovo 143026
Russia

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