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Trading strategy with stochastic volatility in a limit order book market

Author

Listed:
  • Qing-Qing Yang

    (The University of Hong Kong)

  • Wai-Ki Ching

    (The University of Hong Kong)

  • Jiawen Gu

    (Southern University of Science and Technology)

  • Tak-Kuen Siu

    (Macquarie University)

Abstract

In this paper, we employ the Heston stochastic volatility model to describe the stock’s volatility and apply the model to derive and analyze trading strategies for dealers in a security market with price discovery. The problem is formulated as a stochastic optimal control problem, and the controlled state process is the dealer’s mark-to-market wealth. Dealers in the security market can optimally determine their ask and bid quotes on the underlying stocks continuously over time. Their objective is to maximize an expected profit from transactions with a penalty proportional to the variance of cumulative inventory cost. We provide an approximate, analytically tractable solution to the stochastic control problem. Numerical experiments are given to illustrate the effects of various parameters on the performances of trading strategies.

Suggested Citation

  • Qing-Qing Yang & Wai-Ki Ching & Jiawen Gu & Tak-Kuen Siu, 2020. "Trading strategy with stochastic volatility in a limit order book market," Decisions in Economics and Finance, Springer;Associazione per la Matematica, vol. 43(1), pages 277-301, June.
    • Handle: RePEc:spr:decfin:v:43:y:2020:i:1:d:10.1007_s10203-020-00278-8
    DOI: 10.1007/s10203-020-00278-8
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    Cited by:

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    More about this item

    Keywords

    Limit order book (LOB); Dynamic programming (DP); Hamilton–Jacobi–Bellman (HJB) equation; Market impact; Stochastic volatility (SV) model;
    All these keywords.

    JEL classification:

    • C5 - Mathematical and Quantitative Methods - - Econometric Modeling
    • C6 - Mathematical and Quantitative Methods - - Mathematical Methods; Programming Models; Mathematical and Simulation Modeling
    • D8 - Microeconomics - - Information, Knowledge, and Uncertainty
    • D9 - Microeconomics - - Micro-Based Behavioral Economics
    • G4 - Financial Economics - - Behavioral Finance

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