The Endogenous Dynamics of Markets: Price Impact, Feedback Loops and Instabilities

Jean-Philippe Bouchaud

Why do asset prices move so frequently and why is the volatility so high? Why do prices move at all? These are obviously fundamental questions in theoretical economics and quantitative finance, which encompass other, related issues: what is the information reflected by prices, and to what extent market prices reflect the underlying economic reality? Do we understand the origin of crises and crashes?

In this chapter, we review the evidence that the erratic dynamics of markets is to a large extent of endogenous origin, ie, determined by the trading activity itself and not due to the rational processing of exogenous news. In order to understand why and how prices move, the joint fluctuations of order flow and liquidity, and the way in which these impact on prices, become the key ingredients. Impact is necessary for private information to be reflected in prices but, by the same token, random fluctuations in order flow necessarily contribute to the volatility of markets. Our thesis is that the latter contribution is in fact dominant, resulting in a decoupling between prices and fundamental values, at least on short-to-medium timescales. We argue that markets operate in a regime of