The Financial System
F-series
Date:
Number:CARF-F-450
Trade Clustering and Power Laws in Financial Markets (Published in Theoretical Economics, 15:1365–1398, 2020)
Abstract
This study provides an explanation of the emergence of power laws in trading volume and asset returns. In the model, traders infer other traders’ private signals regarding the value of an asset from their actions and adjust their own behavior accordingly. When the number of traders is large and the signals for asset value are noisy, this leads to power laws for equilibrium volume and returns. We also provide numerical results showing that the model reproduces observed distributions of daily stock volume and returns.