Using Simulation to Better Understand Price Determination in a Nonfrictionless Equity Market

Abstract

This article focuses on simulation analysis, a tool that has received relatively sparse attention in the literature. In a laboratory-type environment, simulation can generate data that enable a complex nonfrictionless environment to be assessed in a tractable manner that might not otherwise be readily achievable. This article illustrates these thoughts with reference to Grossman and Stiglitz’s 1976 seminal paper on price formation in an equity market. The authors show that the dynamic process of price formation in a nonfrictionless market can generate returns exhibiting accentuated short-period volatility, kurtosis, and return autocorrelations. They explore several applications of these findings.

TOPICS: Simulations, security analysis and valuation