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From Theory to Application: Using Simulation to Better Understand Price Determination in a Non-Frictionless Equity Market

This paper focuses on an analytic approach that has received relatively sparse application in the economics/finance literature: simulation. Providing a laboratory-type environment, simulation can generate data that enable a com- plex environment to be assessed in a tractable manner that might not otherwise be readily achievable. These thoughts are illustrated with reference to Grossman and Stiglitz’s (1976) seminal paper on price formation in an equity market. Our simulation results show that, as is not the case in a frictionless market, the dynamic pro- cess of price formation in a non-frictionless market can generate returns that exhibit accentuated short-period volatility, kurtosis, and returns autocorrelations.