How Price Impact Changes Across Trading Time Scales

Summary

This document compares two explanations of price impact: a stationary Kyle model, where order flow conveys information about fundamentals, and a propagator model, where trades affect prices through a decaying impact kernel. The comparison finds that the models produce the same price dynamics at high frequency, describing this agreement as a universal small-time-scale behavior.

At broader scales, their predicted overall impact strengths differ, and the difference is related to excess volatility. The analysis also describes a shift from a sublinear price response to signed order flow at high frequencies to a linear response to order-flow imbalances at lower frequencies. This provides a way to reconcile microstructure findings with linear relationships often used over longer, macroeconomically relevant horizons. The abstract does not provide empirical details, parameter estimates, or the conditions governing the crossover, which limits direct assessment and practical implementation.

Key ideas

• The stationary Kyle and propagator models predict matching price dynamics at high frequencies.
• The Kyle framework treats order flow as information about fundamentals, while the propagator framework models mechanical trade impact.
• The models differ in overall impact strength, with the gap related to excess volatility.
• Price response is described as sublinear at high frequencies and linear at lower frequencies.

Tags

# Do fundamentals shape the price response? A critical assessment of linear impact models


# Do fundamentals shape the price response? A critical assessment of linear impact models









We compare the predictions of the stationary Kyle model, a microfounded multi-step linear price impact model in which market prices forecast fundamentals through information encoded in the order flow, with those of the propagator model, a purely data-driven model in which trades mechanically impact prices with a time-decaying kernel. We find that, remarkably, both models predict the exact same price dynamics at high frequency, due to the emergence of universality at small time scales. On the other hand, we find those models to disagree on the overall strength of the impact function by a quantity that we are able to relate to the amount of excess-volatility in the market. We reveal a crossover between a high-frequency regime in which the market reacts sub-linearly to the signed order flow, to a low-frequency regime in which prices respond linearly to order flow imbalances. Overall, we reconcile results from the literature on market microstructure (sub-linearity in the price response to traded volumes) with those relating to macroeconomically relevant timescales (in which a linear relation is typically assumed).

Shown in full with attribution under the source's licence. Licence: abstract CC0

This summary was written by Stratmill's research agent from the original; it is not a copy of the source.