Linear models for the impact of order flow on prices. II: The mixture transition distribution model

DOI10.1080/14697688.2017.1397283zbMATH Open1400.91565arXiv1604.07556OpenAlexW3123490988MaRDI QIDQ4554472FDOQ4554472

Authors: Damian Eduardo Taranto, Jean-Philippe Bouchaud, Fabrizio Lillo, Giacomo Bormetti, Bence Tóth 

Publication date: 14 November 2018

Published in: Quantitative Finance (Search for Journal in Brave)

Abstract: Modeling the impact of the order flow on asset prices is of primary importance to understand the behavior of financial markets. Part I of this paper reported the remarkable improvements in the description of the price dynamics which can be obtained when one incorporates the impact of past returns on the future order flow. However, impact models presented in Part I consider the order flow as an exogenous process, only characterized by its two-point correlations. This assumption seriously limits the forecasting ability of the model. Here we attempt to model directly the stream of discrete events with a so-called Mixture Transition Distribution (MTD) framework, introduced originally by Raftery (1985). We distinguish between price-changing and non price-changing events and combine them with the order sign in order to reduce the order flow dynamics to the dynamics of a four-state discrete random variable. The MTD represents a parsimonious approximation of a full high-order Markov chain. The new approach captures with adequate realism the conditional correlation functions between signed events for both small and large tick stocks and signature plots. From a methodological viewpoint, we discuss a novel and flexible way to calibrate a large class of MTD models with a very large number of parameters. In spite of this large number of parameters, an out-of-sample analysis confirms that the model does not overfit the data.

Full work available at URL: https://arxiv.org/abs/1604.07556

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zbMATH Keywords

Markov chainmarket microstructureprice formationforecasting ability

Mathematics Subject Classification ID

Portfolio theory (91G10)

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Cited In (8)

• Modeling discrete stock price changes using a mixture of Poisson distributions
• State-dependent Hawkes processes and their application to limit order book modelling
• A continuous and efficient fundamental price on the discrete order book grid
• A behavioral finance-based tick-by-tick model for price and volume
• Modeling the coupled return-spread high frequency dynamics of large tick assets
• Deep learning for limit order books
• Capturing the order imbalance with hidden Markov model: a case of SET50 and KOSPI50
• Linear models for the impact of order flow on prices. I. History dependent impact models

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