Modelling Price Pressure in Financial Markets.pdf

Modelling Price Pressure in Financial Markets Elena Asparouhova‡ and Peter Bossaerts§ This version: March 2008 ‡University of Utah, e.asparouhova@ §EPFL Lausanne and CEPR, peter.bossaerts@epfl.ch We thank participants in seminars at Caltech, the Indiana University, the University of Utah, the EFA and EFMA 2004 Meetings. Financial support from the R.J. Jenkins Family Foundation, the National Science Foundation (grant SES- 0079374), and the William D. Hacker Chair at Caltech are gratefully acknowledged. Ultimately only the authors are responsible for remaining errors, however. 1 Modeling Price Pressure in Financial Markets Abstract We present experimental evidence that security prices do not respond to pressure from their own excess demand, unlike traditionally assumed in economic theory. Instead, prices respond to excess demand of all securities, despite the absence of a direct link between markets. We propose a model of price pressure that explains these findings. In our model, agents set order prices that reflect the marginal valuation of desired future holdings, called “aspiration levels.” In the short run, as agents encounter difficulties executing their orders, they scale back their aspi- ration levels. Marginal valuations, order prices, and hence, transaction prices change correspondingly. The resulting price adjustment process coincides with the Global Newton Method. The assumptions of the model as well its empirical implications are fully borne out by the data. Our model thus provides economic foundation for why markets appear to search for equilibrium according