Market Microstructure Invariance: A Dynamic Equilibrium Model
56 Pages Posted: 12 Feb 2019 Last revised: 31 Mar 2020
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: Suggested Citation