# Economic Fluctuations and Diffusion

## Abstract

Stock price changes occur through transactions, just as diffusion in physical systems occurs through molecular collisions. We systematically explore this analogy  and quantify the relation between trading activity — measured by the number of transactions $`N_{\mathrm{\Delta }t}`$ — and the price change $`G_{\mathrm{\Delta }t}`$ for a given stock, over a time interval $`[t,t+\mathrm{\Delta }t]`$. To this end, we analyze a database documenting every transaction for 1000 US stocks over the two-year period 1994–1995 . We find that price movements are equivalent to a complex variant of diffusion, where the diffusion coefficient fluctuates drastically in time. We relate the analog of the diffusion coefficient to two microscopic quantities: (i) the number of transactions $`N_{\mathrm{\Delta }t}`$ in $`\mathrm{\Delta }t`$, which is the analog of the number of collisions and (ii) the local variance $`w_{\mathrm{\Delta }t}^2`$ of the price changes for all transactions in $`\mathrm{\Delta }t`$, which is the analog of the local mean square displacement between collisions. We study the distributions of both $`N_{\mathrm{\Delta }t}`$ and $`w_{\mathrm{\Delta }t}`$, and find that they display power-law tails. Further, we find that $`N_{\mathrm{\Delta }t}`$ displays long-range power-law correlations in time, whereas $`w_{\mathrm{\Delta }t}`$ does not. Our results are consistent with the interpretation that the pronounced tails of the distribution of $`G_{\mathrm{\Delta }t}`$  are due to $`w_{\mathrm{\Delta }t}`$, and that the long-range correlations previously found  for $`|G_{\mathrm{\Delta }t}|`$ are due to $`N_{\mathrm{\Delta }t}`$.

Consider the diffusion  of an ink particle in water. Starting out from a point, the ink particle undergoes a random walk due to collisions with the water molecules. The distance covered by the particle after a time $`\mathrm{\Delta }t`$ is

$$x_{\mathrm{\Delta }t}=\underset{i=1}{\overset{N_{\mathrm{\Delta }t}}{}}\delta x_i,$$
(2)   
where $`\delta x_i`$ are the distances that the particle moves in between collisions, and $`N_{\mathrm{\Delta }t}`$ denotes the number of collisions during the interval $`\mathrm{\Delta }t`$. The distribution $`P(x_{\mathrm{\Delta }t})`$ is Gaussian with a variance $`x_{\mathrm{\Delta }t}^2=N_{\mathrm{\Delta }t}w_{\mathrm{\Delta }t}^2`$, where the local mean square displacement $`w_{\mathrm{\Delta }t}^2(\delta x_i)^2`$ is the variance of the individual steps $`\delta x_i`$ in the interval $`[t,t+\mathrm{\Delta }t]`$.

For the classic diffusion problem considered above: (i) the probability distribution $`P(N_{\mathrm{\Delta }t})`$ is a “narrow” Gaussian, i.e., has a standard deviation much smaller than the mean $`N_{\mathrm{\Delta }t}`$, (ii) the time between collisions of an ink particle are not strongly correlated, so $`N_{\mathrm{\Delta }t}`$ at any future time $`t+\tau `$ depends at most weakly on $`N_{\mathrm{\Delta }t}`$ at time $`t`$—i.e., the correlation function $`N_{\mathrm{\Delta }t}(t)N_{\mathrm{\Delta }t}(t+\tau )`$ has a short-range exponential decay, (iii) the distribution $`P(w_{\mathrm{\Delta }t})`$ is also a narrow Gaussian, (iv) the correlation function $`w_{\mathrm{\Delta }t}(t)w_{\mathrm{\Delta }t}(t+\tau )`$ has a short-range exponential decay and (v) the variable $`ϵx_{\mathrm{\Delta }t}/(w_{\mathrm{\Delta }t}\sqrt{N_{\mathrm{\Delta }t}})`$ is uncorrelated and Gaussian-distributed. These conditions result in $`x_{\mathrm{\Delta }t}`$ being Gaussian distributed and weakly correlated.

An ink particle diffusing under more general conditions would result in a quite different distribution of $`x_{\mathrm{\Delta }t}`$, such as in a bubbling hot spring, where the characteristics of bubbling depend on a wide range of time and length scales. In the following, we will present empirical evidence that the movement of stock prices is equivalent to a complex variant of classic diffusion, specified by the following conditions: (i) $`P(N_{\mathrm{\Delta }t})`$ is not a Gaussian, but has a power-law tail, (ii) $`N_{\mathrm{\Delta }t}`$ has long-range power-law correlations, (iii) $`P(w_{\mathrm{\Delta }t})`$ is not a Gaussian, but has a power-law tail, (iv) the correlation function $`w_{\mathrm{\Delta }t}(t)w_{\mathrm{\Delta }t}(t+\tau )`$ is short ranged, and (v) the variable $`ϵx_{\mathrm{\Delta }t}/(w_{\mathrm{\Delta }t}\sqrt{N_{\mathrm{\Delta }t}})`$ is Gaussian distributed and short-range correlated. Under these conditions, the statistical properties of $`x_{\mathrm{\Delta }t}`$ will depend on the exponents characterizing these power laws.

Just as the displacement $`x_{\mathrm{\Delta }t}`$ of a diffusing ink particle is the sum of $`N_{\mathrm{\Delta }t}`$ individual displacements $`\delta x_i`$, so also the stock price change $`G_{\mathrm{\Delta }t}`$ is the sum of the price changes $`\delta p_i`$ of the $`N_{\mathrm{\Delta }t}`$ transactions in the interval $`[t,t+\mathrm{\Delta }t]`$,

$$G_{\mathrm{\Delta }t}=\underset{i=1}{\overset{N_{\mathrm{\Delta }t}}{}}\delta p_i.$$
(3)   
Figure 1a shows $`N_{\mathrm{\Delta }t}`$ for classic diffusion and for one stock (Exxon Corporation). The number of trades for Exxon displays several events the size of tens of standard deviations and hence is inconsistent with a Gaussian process .

(i) We first analyze the distribution of $`N_{\mathrm{\Delta }t}`$. Figure 1c shows that the cumulative distribution of $`N_{\mathrm{\Delta }t}`$ displays a power-law behavior $`P\{N>x\}x^\beta `$. For the 1000 stocks analyzed, we obtain a mean value $`\beta =3.40\pm 0.05`$ (Fig. 1d). Note that $`\beta >2`$ is outside the Lévy stable domain $`0<\beta <2`$.

(ii) We next determine the correlations in $`N_{\mathrm{\Delta }t}`$. We find that the correlation function $`N_{\mathrm{\Delta }t}(t)N_{\mathrm{\Delta }t}(t+\tau )`$ is not exponentially decaying as in the case of classic diffusion, but rather displays a power-law decay (Fig. 1e,f). This result quantifies the qualitative fact that if the trading activity ($`N_{\mathrm{\Delta }t}`$) is large at any time, it is likely to remain so for a considerable time thereafter.

(iii) We then compute the variance $`w_{\mathrm{\Delta }t}^2(\delta p_i)^2`$ of the individual changes $`\delta p_i`$ due to the $`N_{\mathrm{\Delta }t}`$ transactions in the interval $`[t,t+\mathrm{\Delta }t]`$ (Fig. 2a). We find that the distribution $`P(w_{\mathrm{\Delta }t})`$ displays a power-law decay $`P\{w_{\mathrm{\Delta }t}>x\}x^\gamma `$ (Fig. 2b). For the 1000 stocks analyzed, we obtain a mean value of the exponent $`\gamma =2.9\pm 0.1`$ (Fig. 2c).

(iv) Next, we quantify correlations in $`w_{\mathrm{\Delta }t}`$. We find that the correlation function $`w_{\mathrm{\Delta }t}(t)w_{\mathrm{\Delta }t}(t+\tau )`$ shows only weak correlations (Fig. 2d,e). This means that $`w_{\mathrm{\Delta }t}`$ at any future time $`t+\tau `$ depends at most weakly on $`w_{\mathrm{\Delta }t}`$ at time $`t`$.

(v) Consider now $`\delta p_i`$ chosen only from the interval $`[t,t+\mathrm{\Delta }t]`$, and let us hypothesize that these $`\delta p_i`$ are mutually independent and with a common distribution $`P(\delta p_i|t[t,t+\mathrm{\Delta }t])`$ having a finite variance $`w_{\mathrm{\Delta }t}^2`$. Under this hypothesis, the central limit theorem implies that the ratio

$$ϵ\frac{G_{\mathrm{\Delta }t}}{w_{\mathrm{\Delta }t}\sqrt{N_{\mathrm{\Delta }t}}}$$
(4)   
must be a Gaussian-distributed random variable with zero mean and unit variance . Indeed, for classic diffusion, $`x_{\mathrm{\Delta }t}/(w_{\mathrm{\Delta }t}\sqrt{N_\mathrm{\Delta }})`$ is Gaussian-distributed and uncorrelated (Fig. 3a). We confirm this hypothesis by analyzing (a) the distribution $`P(ϵ)`$, which we find to be consistent with Gaussian behavior (Fig. 3b), and (b) the correlation function $`ϵ(t)ϵ(t+\tau )`$, for which we find only short-range correlations (Fig. 3c,d).

Thus far, we have seen that the data for stock price movements support the following results: (i) the distribution of $`N_{\mathrm{\Delta }t}`$ decays as a power-law, (ii) $`N_{\mathrm{\Delta }t}`$ has long-range correlations, (iii) the distribution of $`w_{\mathrm{\Delta }t}`$ decays as a power-law, (iv) $`w_{\mathrm{\Delta }t}`$ displays only weak correlations, and (v) the price change $`G_{\mathrm{\Delta }t}`$ at any time is consistent with a Gaussian-distributed random variable  with a time-dependent variance $`N_{\mathrm{\Delta }t}w_{\mathrm{\Delta }t}^2`$, that is, the variable $`ϵG_{\mathrm{\Delta }t}/(w_{\mathrm{\Delta }t}\sqrt{N_{\mathrm{\Delta }t}})`$ is Gaussian-distributed and uncorrelated.

Next, we explore the implications of our empirical findings. Namely, we show how the statistical properties  of price changes $`G_{\mathrm{\Delta }t}`$ can be understood in terms of the properties of $`N_{\mathrm{\Delta }t}`$ and $`w_{\mathrm{\Delta }t}`$. We will argue that the pronounced tails of the distribution of price changes  are largely due to $`w_{\mathrm{\Delta }t}`$ and the long-range correlations previously found  for $`|G_{\mathrm{\Delta }t}|`$ are largely due to the long-range correlations in $`N_{\mathrm{\Delta }t}`$. By contrast, in classic diffusion $`N_{\mathrm{\Delta }t}`$ and $`w_{\mathrm{\Delta }t}`$ do not change the Gaussian behavior of $`x_{\mathrm{\Delta }t}`$ because they have only uncorrelated Gaussian-fluctuations .

Consider first the distribution of price changes $`G_{\mathrm{\Delta }t}`$, which decays as a power-law $`P\{G_{\mathrm{\Delta }t}>x\}x^\alpha `$ with an exponent $`\alpha 3`$ . Above, we reported that the distribution $`P\{N_{\mathrm{\Delta }t}>x\}x^\beta `$ with $`\beta 3.4`$ (Fig. 1c,d). Therefore, $`P\{\sqrt{N_{\mathrm{\Delta }t}}>x\}x^{2\beta }`$ with $`2\beta 6.8`$. Equation (4) then implies that $`N_{\mathrm{\Delta }t}`$ alone cannot explain the value $`\alpha 3`$. Instead, $`\alpha 3`$ must arise from the distribution of $`w_{\mathrm{\Delta }t}`$, which indeed decays with approximately the same exponent $`\gamma \alpha 3`$ (Fig. 2b,c). Thus the power-law tails in $`P(G_{\mathrm{\Delta }t})`$ appear to originate from the power-law tail in $`P(w_{\mathrm{\Delta }t})`$.

Next, consider the long-range correlations found for $`|G_{\mathrm{\Delta }t}|`$ . Above, we reported that $`N_{\mathrm{\Delta }t}`$ displays long-range correlations, whereas $`w_{\mathrm{\Delta }t}`$ does not (Figs. 1–2). Therefore, the long range correlations in $`|G_{\mathrm{\Delta }t}|`$ should arise from those found in $`N_{\mathrm{\Delta }t}`$. Hence, while the power-law tails in $`P(G_{\mathrm{\Delta }t})`$ are due to the power-law tails in $`P(w_{\mathrm{\Delta }t})`$, the long-range correlations of $`|G_{\mathrm{\Delta }t}|`$ are due to those of $`N_{\mathrm{\Delta }t}`$.

In sum, we have shown that stock price movements are analogous to a complex variant of classic diffusion. Further, we have empirically demonstrated the relation between stock price changes and market activity, i.e., the price change at any time $`G_{\mathrm{\Delta }t}(t)`$ is consistent with a Gaussian-distributed random variable with a local variance $`N_{\mathrm{\Delta }t}w_{\mathrm{\Delta }t}^2`$. What could be the interpretations of our results for the number of transactions $`N_{\mathrm{\Delta }t}`$ and the local standard deviation $`w_{\mathrm{\Delta }t}`$? Since $`N_{\mathrm{\Delta }t}`$ measures the trading activity for a given stock, it is possible that its power-law distribution and long-range correlations may be related to “avalanches” . The fluctuations in $`w_{\mathrm{\Delta }t}`$ reflect several factors: (i) the level of liquidity of the market, (ii) the risk-aversion of the market participants and (iii) the uncertainty about the fundamental value of the asset.

e) In order to accurately quantify time correlations in $`N_{\mathrm{\Delta }t}`$, we use the method of detrended fluctuations  often used to obtain accurate estimates of power-law correlations. We plot the detrended fluctuations $`F(\tau )`$ as a function of the time scale $`\tau `$ on a log-log scale for each of the 6 groups. Absence of long-range correlations would imply $`F(\tau )\tau ^{0.5}`$, whereas $`F(\tau )\tau ^\nu `$ with $`0.5<\nu 1`$ show power-law correlations with long-range persistence. For each group, we plot $`F(\tau )`$ averaged over all stocks in that group. In order to detect genuine long-range correlations, the U-shaped intraday pattern for $`N_{\mathrm{\Delta }t}`$ has been removed by dividing each $`N_{\mathrm{\Delta }t}`$ by the intraday pattern . For $`0.5<\nu <1.0`$, correlation function exponent $`\nu _{cf}`$ and $`\nu `$ are related through $`\nu _{cf}=22\nu `$. f) The histogram of the exponents $`\nu `$ obtained by fits to $`F(\tau )`$ for each of the 1000 stocks shows a relatively narrow spread of $`\nu `$ around the mean value $`\nu =0.85\pm 0.01`$.