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'Noise-trader risk' and Bayesian market making in FX derivatives: rolling loaded dice?

  • Carlos A. Ulibarri

    (Department of Management, New Mexico Institute of Mining and Technology, USA)

  • Peter C. Anselmo

    (Department of Management, New Mexico Institute of Mining and Technology, USA)

  • Karen Hovespian

    (Department of Management, New Mexico Institute of Mining and Technology, USA)

  • Jacob Tolk

    (Department of Management, New Mexico Institute of Mining and Technology, USA)

  • Ionut Florescu

    (Department of Mathematical Sciences, Stevens Institute of Technology, USA)

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. Copyright © 2008 John Wiley & Sons, Ltd.

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File URL: http://hdl.handle.net/10.1002/ijfe.373
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Article provided by John Wiley & Sons, Ltd. in its journal International Journal of Finance & Economics.

Volume (Year): 14 (2009)
Issue (Month): 3 ()
Pages: 268-279

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Handle: RePEc:ijf:ijfiec:v:14:y:2009:i:3:p:268-279
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