This paper proposes a mathematical model of financial markets as networks. The model examines the effect of network structure on market behavior (price volatility and trading volume). In the model, investors are arrayed in various network configurations through which they gather information to make trading decisions. The basic network considered is a chain graph with two parameters, number of investors (n) and the length of time in which information is transmitted (k). Closed‐form expressions for price volatility and expected trading volume are provided. The model is generalized to more complex networks, focusing on the hub‐and‐spoke network. The network configurations analyzed do not represent the real (and unknown) communication network among investors, but predictions from the model are consistent with price and volume patterns observed in sociological and economic research on financial markets. The main result is that network structure alone influences price volatility and expected trading volume even though investors are homogeneous and the information introduced into the system is unbiased and random. This result suggests that the structure of the real communication network among investors may influence market behavior.
Notes
We gratefully acknowledge the helpful comments and suggestions provided by Gary Becker, James Coleman, Edward Laumann, George Loewenstein, John Padgett, Mark Shanley, Arnold Zellner and the editor of this journal. Earlier versions of this paper were presented at the annual meetings of the International Sunbelt Social Network Conference, Tampa, FL (1989), the Academy of Management, Washington, DC (1989), the ORSA/ITMS Joint National Conference, New York City (1989), and James Coleman's seminar on Mathematical Sociology (1990).