The Inelastic Market Hypothesis: A Microstructural Interpretation


Abstract in English

We attempt to reconcile Gabaix and Koijens (GK) recent Inelastic Market Hypothesis with the order-driven view of markets that emerged within the microstructure literature in the past 20 years. We review the most salient empirical facts and arguments that give credence to the idea that market price fluctuations are mostly due to order flow, whether informed or non-informed. We show that the Latent Liquidity Theory of price impact makes a precise prediction for GKs multiplier $M$, which measures by how many dollars, on average, the market value of a company goes up if one buys one dollar worth of its stocks. Our central result is that $M$ increases with the volatility of the stock and decreases with the fraction of the market cap. that is traded daily. We discuss several empirical results suggesting that the lions share of volatility is due to trading activity.

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