Can we infer microscopic financial information from the long memory in market-order flow?: a quantitative test of the Lillo-Mike-Farmer model

Abstract

In financial markets, the market order sign exhibits strong persistence, widely known as the long-range correlation (LRC) of order flow; specifically, the sign correlation function displays long memory with power-law exponent $\gamma$, such that $C(\tau )\propto {\tau }^{-\gamma }$ for large time-lag $\tau$. One of the most promising microscopic hypotheses is the order-splitting behaviour at the level of individual traders. Indeed, Lillo, Mike, and Farmer (LMF) introduced in 2005 a simple microscopic model of order-splitting behaviour, which predicts that the macroscopic sign correlation is quantitatively associated with the microscopic distribution of metaorders. While this hypothesis has been a central issue of debate in econophysics, its direct quantitative validation has been missing because it requires large microscopic datasets with high resolution to observe the order-splitting behaviour of all individual traders. Here we present the first quantitative validation of this LFM prediction by analysing a large microscopic dataset in the Tokyo Stock Exchange market for more than nine years. On classifying all traders as either order-splitting traders or random traders as a statistical clustering, we directly measured the metaorder-length distributions $P(L)\propto L^{-\alpha -1}$ as the microscopic parameter of the LMF model and examined the theoretical prediction on the macroscopic order correlation: $\gamma \approx \alpha -1$. We discover that the LMF prediction agrees with the actual data even at the quantitative level. Our work provides the first solid support of the microscopic model and solves directly a long-standing problem in the field of econophysics and market microstructure.

4 pages, 4 figures

References in corpus (3)

• Power-law distributions in empirical data
• Social physics
• Quantitative statistical analysis of order-splitting behaviour of individual trading accounts in the Japanese stock market over nine years

Cited by in corpus (3)

• Quantitative statistical analysis of order-splitting behaviour of individual trading accounts in the Japanese stock market over nine years
• Strict universality of the square-root law in price impact across stocks: a complete survey of the Tokyo stock exchange
• Exact solution to a generalised Lillo-Mike-Farmer model with heterogeneous order-splitting strategies