✦ LIBER ✦

‘Noise-trader risk’ and Bayesian market making in FX derivatives: rolling loaded dice?

✍ Scribed by Carlos A. Ulibarri; Peter C. Anselmo; Karen Hovespian; Jacob Tolk; Ionut Florescu

Book ID: 102278265
Publisher: John Wiley and Sons
Year: 2009
Tongue: English
Weight: 160 KB
Volume: 14
Category: Article
ISSN: 1076-9307
DOI: 10.1002/ijfe.373

No coin nor oath required. For personal study only.

✦ Synopsis

Abstract

This paper develops and simulates a model of a Bayesian market maker who transacts with noise and position traders in derivative markets. The impact of noise trading is examined relative to price determination in FX futures, noise transmission from futures to options, and risk‐management behaviour linking the two markets. The model simulations show noise trading in futures results in wider bid–ask spreads, increased price volatility, and greater variation in hedging costs. Above all, the Bayesian market maker manages price‐risk by trend chasing not for speculative purposes, but to avoid being caught on the wrong side of the market. The pecuniary effects from this risk‐management strategy suggest that noise trading tends to constrain the market maker's capacity to arbitrage; particularly when the underlying price is mean averting as opposed to a Martingale and trading sessions exhibit significant price volatility. Copyright © 2008 John Wiley & Sons, Ltd.