TY - JOUR
T1 - 'Noise-trader risk' and Bayesian market making in FX derivatives
T2 - Rolling loaded dice?
AU - Ulibarri, Carlos A.
AU - Anselmo, Peter C.
AU - Hovespian, Karen
AU - Tolk, Jacob
AU - Florescu, Ionut
PY - 2009
Y1 - 2009
N2 - 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.
AB - 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.
KW - Bayesian agent
KW - FX derivatives
KW - Market making
KW - Noise trading
KW - Noise transmission
UR - http://www.scopus.com/inward/record.url?scp=70350161761&partnerID=8YFLogxK
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U2 - 10.1002/ijfe.373
DO - 10.1002/ijfe.373
M3 - Article
AN - SCOPUS:70350161761
SN - 1076-9307
VL - 14
SP - 268
EP - 279
JO - International Journal of Finance and Economics
JF - International Journal of Finance and Economics
IS - 3
ER -