On the probability distribution of stock returns in the Mike-Farmer model

Abstract: Recently, Mike and Farmer have constructed a very powerful and realistic behavioral model to mimick the dynamic process of stock price formation based on the empirical regularities of order placement and cancelation in a purely order-driven market, which can successfully reproduce the whole distribution of returns, not only the well-known power-law tails, together with several other important stylized facts. There are three key ingredients in the Mike-Farmer (MF) model: the long memory of order signs characterized by the Hurst index

H_{s}

, the distribution of relative order prices

x

in reference to the same best price described by a Student distribution (or Tsallis'

q

-Gaussian), and the dynamics of order cancelation. They showed that different values of the Hurst index

H_{s}

and the freedom degree

a l p h a_{x}

of the Student distribution can always produce power-law tails in the return distribution

f (r)

with different tail exponent

a l p h a_{r}

. In this paper, we study the origin of the power-law tails of the return distribution

f (r)

in the MF model, based on extensive simulations with different combinations of the left part

f_{L} (x)

for

x < 0

and the right part

f_{R} (x)

for

x > 0

of

f (x)

. We find that power-law tails appear only when

f_{L} (x)

has a power-law tail, no matter

f_{R} (x)

has a power-law tail or not. In addition, we find that the distributions of returns in the MF model at different timescales can be well modeled by the Student distributions, whose tail exponents are close to the well-known cubic law and increase with the timescale.

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