Reconciling Competitive And Strategic Approaches To Price Discovery In Financial Markets: The Empirical Evidence

Price dynamics are studied on the basis of more than 11,000 transactions from twelve large-scale financial markets experiments. Transaction price changes are strongly correlated with the excess demands that form the core of competitive general equilibrium theory. The evidence for market microstructure theory (which focuses on strategic interaction, appealing to game theory) is more qualified. On the one hand, more predictability is uncovered than expected by chance. In particular, imbalances in the book too often predict subsequent transaction price changes. On the other hand, the nature of the predictability changes in unstructured ways, rendering it essentially useless. Weighted average quotes in the book strongly correlate with excess demands, providing evidence for a link between (competitive) general equilibrium theory and (strategic) market microstructure theory. There is no inconsistency in the findings that transaction price changes correlate with excess demands yet not with information in the book (at least not in structured ways) while at the same time the book correlates with excess demands. Indeed, the findings can be reconciled because weighted average quotes in the book explain part of the variance of transaction price changes that is unaccounted for by excess demands.