Chapter 10. Trading on Market Microstructure: Inventory Models

Rational expectations and the efficient markets hypotheses imply that, following a relevant news release, market prices adjust instantaneously. From the perspective of a long-term investor, holding positions for days or months, the adjustment may indeed seem instantaneous. Anyone who has watched the markets surrounding a major news release, however, has observed a different picture—a volatile price that eventually settles within a specific price band. Note that the price eventually settles within a price range and not at a constant price level, because a degree of volatility, however small, accompanies all market conditions. The process of the market finding its optimal post-announcement price band is often referred to as tâtonnement, from French for "trial and error."

Figure 10.1 illustrates price adjustments as viewed at different frequencies. At very high frequencies, the price adjustment process is hardly instantaneous. The tâtonnement toward a new optimal price happens through the implicit negotiation among buyers and sellers that is occurring in the order flow; the market participants develop individual security valuations given the news, which are reflected in their bids and asks. These quotes provide market participants with information about other market participants' valuations. The process repeats until most market participants agree on a range of acceptable prices; the equilibrium price band can then be considered ...

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