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Ambiguous price formation

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  • Aliyev, Nihad
  • He, Xue-Zhong

Abstract

We study the price and liquidity of an asset in a model where market makers face ambiguity about the asset payoff. This ambiguity explains liquidity deteriorations and improvements in financial markets. We show that the ambiguity influences how market makers perceive adverse selection risk, and therefore, distorts market liquidity. The perceived adverse selection risk increases (resp. decreases) with the ambiguity when the market maker is sufficiently (resp. insufficiently) ambiguity averse. Our model also helps to understand how ambiguity and ambiguity aversion of market makers impact price and liquidity dynamics under various trading histories.

Suggested Citation

  • Aliyev, Nihad & He, Xue-Zhong, 2023. "Ambiguous price formation," Journal of Mathematical Economics, Elsevier, vol. 106(C).
    • Handle: RePEc:eee:mateco:v:106:y:2023:i:c:s0304406823000356
    DOI: 10.1016/j.jmateco.2023.102842
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