A study of the diffusion of asset prices: the determinants of asset price diffusion and a practical model of asset price diffusion for use in portfolio management

Abstract

[Abstract]: Brownian motion and diffusion processes have found considerable application in modern finance theory. In this paper, the diffusion coefficients of stock prices for the S&P/ASX300 are computed and analysed. Reasoning by analogy (from theoretical physics), market capitalisation and liquidity are identified as two variables that may be expected to explain the variance of the diffusion coefficients of stock prices. The analysis presented herein reveals that the actual relationship between these variables is not in accordance with expectations of the directions of the relationships derived by reasoning from physics to finance. In addition, the utilisation of asset price diffusion coefficients in portfolio management is discussed. Diffusion coefficients may play an extremely useful role in practice as ‘transition probabilities’: the probability that a particular change in the asset’s price will be observed in a particular period of time and may be used to compute the expected value of a price movement.