Ambiguous Market Making

Nihad Aliyev and Xuezhong (Tony) He
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Nihad Aliyev: Finance Discipline Group, UTS Business School, University of Technology Sydney

No 383, Research Paper Series from Quantitative Finance Research Centre, University of Technology, Sydney

Abstract: This paper investigates the impact of informational ambiguity and attitude to it on security prices. Attention is focused on equilibria in which a market maker has an ambiguity in his probability assessment. We show that the equilibrium ambiguous bid-ask spread can be decomposed into the probabilistic spread and an “ambiguity premium/discount” component characterizing the ambiguity aversion/seeking of the market maker. In particular, for a sufficiently ambiguity averse market maker, the bid-ask spread widens with the informational ambiguity of the market maker, which provides an explanation to drying liquidity and price inefficiency during financial turmoils. An extension to different trade sizes shows that informed traders are more likely to trade large orders when there is a major ambiguous shock to the economy.

Keywords: market microstructure; informational ambiguity; Choquet expectation; generalized Bayesian updating; non-additive probability (search for similar items in EconPapers)
JEL-codes: D81 D82 G14 (search for similar items in EconPapers)
Pages: 34 pages
Date: 2017-05-01
New Economics Papers: this item is included in nep-dcm, nep-ore and nep-upt
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