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Optimal Bid-Ask Spread in Limit-Order Books under Regime Switching Framework

Author

Listed:
  • Farzad Alavi Fard

    (School of Economics, Finance and Marketing, RMIT University, 445 Swanson Street, Melbourne, VIC 3000, AUSTRALIA)

Abstract

This paper advocates a regime-switching model to capture the risk of structural changes in the economy, when determining the optimal bid-ask spread in limit order books. In our model, the market-maker faces an inventory risk due to the diffusive nature of the stocks¡¯ mid-price and a transactions risk due to a Poisson arrival of market ¡°buy¡± and ¡°sell¡± orders. We propose that the intensity of the orders depend on the state of the economy, and in the event of a structural change, market makers will face different intensity of order flows, reflecting the new market conditions. In our model, the dealer is a wealth maximizing agent who dynamically manages his portfolio. We employ Hamilton-Jacobi-Bellman equation for the dynamic programming problem, and we solve the problem numerically using the Galerkin method.

Suggested Citation

  • Farzad Alavi Fard, 2014. "Optimal Bid-Ask Spread in Limit-Order Books under Regime Switching Framework," Review of Economics & Finance, Better Advances Press, Canada, vol. 4, pages 33-48, November.
    • Handle: RePEc:bap:journl:140403
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    References listed on IDEAS

    as
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    Cited by:

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    More about this item

    Keywords

    Market micro-structure; Limit-order; Regime switching; HJB; Galerkin method;
    All these keywords.

    JEL classification:

    • C61 - Mathematical and Quantitative Methods - - Mathematical Methods; Programming Models; Mathematical and Simulation Modeling - - - Optimization Techniques; Programming Models; Dynamic Analysis
    • C02 - Mathematical and Quantitative Methods - - General - - - Mathematical Economics
    • D43 - Microeconomics - - Market Structure, Pricing, and Design - - - Oligopoly and Other Forms of Market Imperfection
    • D58 - Microeconomics - - General Equilibrium and Disequilibrium - - - Computable and Other Applied General Equilibrium Models
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions

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