The underlying mechanism in exchange rate behavior is similar to that of microparticles in fluid, a team of researchers from Japan and Switzerland have found. They explained that the swings in exchange rates and market prices have the same foundations as molecule movements in physics.
When the scientists observe tiny particles, such as bacteria or nanoparticles in fluid under a microscope, they do not see a static image. They detect miniscule particles making subtle irregular twitches similar to the fluctuations of exchange rates and market prices.
The random twitching observed in price developments on the financial market and microparticles in fluid “are not just similar at first sight….the underlying mechanism is the same too,” the researchers wrote.
Brownian motion
Their study, titled “Financial Brownian Particle in the Layered Order-Book Fluid and Fluctuation-Dissipation Relations,” has been published in the journal Physical Review Letters.
The microtwitching of particles in fluid is known scientifically as “Brownian Motion”. It results from the “impact of the universal thermal agitation of the individual molecules in the fluid.”
Louis Bachelier (1870-1946), a French mathematician, discussed the use of Brownian motion to evaluate stock options at the beginning of the 20th century.
It is only now, however, over one hundred years later that Didier Sornette at ETH (Eidgenössische Technische Hochschule, Federal Institute of Technology) Zürich and his Japanese colleagues have been able to demonstrate specific correlations between the two.
Eisntein’s theorem and stock exchanges
Sornetter explained:
“Microparticles are surrounded and moved around by the molecules in the fluid. Similarly, the price at which securities or currencies are traded on a financial market should not be examined in isolation either.”
It is much more the case that this price forms part at all times of a larger whole, in the sum of buying and selling orders of stockbrokers’ clients. When the number of these orders exceeds that of the actual transactions, many bids will not result in any transactions.
This occurs, for example, when a potential buyer is only willing to pay a relatively low price for a security, but nobody wants to sell for such a low price. Or when somebody wants to sell for a high price but cannot find any willing buyers.
Bids and exchange rates influence each other. They are spurred on by the continuous efforts of all market players to make a profit by exploiting price differences. This means that stockbrokers’ order books are always in constant motion.
Sornette said:
“This – dynamic – behavior of all orders is comparable to the physical behavior and influence of fluids on a Brownian particle, in the sense that the dynamics of the order book influences the observed transaction price in a precise way.”
Sornette and team checked their theory against available market data by using information from a multinational brokering company on the dollar-yen exchange rate.
They were even able to demonstrate that the sum of orders for the buying and selling of dollars and yen met the fluctuation-dissipation theorem developed by Albert Einstein in 1905.