Market Microstructure and Price Discovery

Abstract

The design of this study is to investigate the evolution of a stochastic price process consequent to discrete processes of bids and offers in a market microstructure setting. Under a set of flexible assumptions about agent preferences, we gen-erate a price process to compare with observation. Specifically, we allow for both rational and irrational economic be-havior, abstracting the inquiry from classical studies relying on utility theory. The goal is to provide a set of economic primitives which point inexorably to the price processes we see, rather than to assume such process from the start.