IDEAS home Printed from https://ideas.repec.org/p/arx/papers/2607.17991.html

Optimal Market Making in Prediction Markets

Author

Listed:
  • Dominik Feil
  • Max Nendel

Abstract

Prediction markets are attracting growing attention as trading volumes rise and their practical relevance increases. To ensure efficient price discovery, liquidity provision becomes ever more important. Due to the binary settlement structure in prediction markets, optimal market making leads to an optimization problem that is fundamentally different from the ones studied in classical settings. In this paper, we develop a stochastic control framework for prediction markets in which the market price is modeled as a conditional probability of the outcome that is generated by a transformed latent belief diffusion. A market maker selects bid and ask quotes to maximize expected terminal wealth while controlling both mark-to-market inventory risk and the settlement risk of remaining positions at resolution. We derive the associated Hamilton--Jacobi--Bellman equation and characterize the unique optimal bid and ask quotes. By transforming the equation to the latent belief space and using a fixed-point argument, we prove existence and uniqueness of a classical solution and verify the resulting optimal quoting strategy. In addition, we provide a numerical analysis, which reveals how optimal liquidity provision in prediction markets depends on inventory, market beliefs, time to resolution, and risk aversion. Further, we demonstrate that the optimal quoting strategy substantially improves downside protection while preserving most of its expected profit relative to a myopic benchmark that maximizes the instantaneous expected mark-to-market profit.

Suggested Citation

  • Dominik Feil & Max Nendel, 2026. "Optimal Market Making in Prediction Markets," Papers 2607.17991, arXiv.org.
  • Handle: RePEc:arx:papers:2607.17991
    as

    Download full text from publisher

    File URL: https://arxiv.org/pdf/2607.17991
    File Function: Latest version
    Download Restriction: no
    ---><---

    References listed on IDEAS

    as
    1. Álvaro Cartea & Sebastian Jaimungal, 2015. "Risk Metrics And Fine Tuning Of High-Frequency Trading Strategies," Mathematical Finance, Wiley Blackwell, vol. 25(3), pages 576-611, July.
    2. Bastien Baldacci & Philippe Bergault & Olivier Guéant, 2021. "Algorithmic market making for options," Quantitative Finance, Taylor & Francis Journals, vol. 21(1), pages 85-97, January.
    3. Robin Hanson, 2003. "Combinatorial Information Market Design," Information Systems Frontiers, Springer, vol. 5(1), pages 107-119, January.
    4. repec:hal:journl:hal-03885125 is not listed on IDEAS
    5. Bo Cowgill & Eric Zitzewitz, 2015. "Corporate Prediction Markets: Evidence from Google, Ford, and Firm X," The Review of Economic Studies, Review of Economic Studies Ltd, vol. 82(4), pages 1309-1341.
    6. Ho, Thomas & Stoll, Hans R., 1981. "Optimal dealer pricing under transactions and return uncertainty," Journal of Financial Economics, Elsevier, vol. 9(1), pages 47-73, March.
    7. Berg, Joyce E. & Nelson, Forrest D. & Rietz, Thomas A., 2008. "Prediction market accuracy in the long run," International Journal of Forecasting, Elsevier, vol. 24(2), pages 285-300.
    8. Shaw Dalen, 2025. "Toward Black Scholes for Prediction Markets: A Unified Kernel and Market Maker's Handbook," Papers 2510.15205, arXiv.org, revised Apr 2026.
    9. Alexander Barzykin & Philippe Bergault & Olivier Guéant, 2023. "Algorithmic market making in dealer markets with hedging and market impact," Mathematical Finance, Wiley Blackwell, vol. 33(1), pages 41-79, January.
    10. Olivier Gu'eant, 2016. "Optimal market making," Papers 1605.01862, arXiv.org, revised May 2017.
    11. Kaj Nyström & Sidi Mohamed Ould Aly & Changyong Zhang, 2014. "Market Making And Portfolio Liquidation Under Uncertainty," International Journal of Theoretical and Applied Finance (IJTAF), World Scientific Publishing Co. Pte. Ltd., vol. 17(05), pages 1-33.
    Full references (including those not matched with items on IDEAS)

    Most related items

    These are the items that most often cite the same works as this one and are cited by the same works as this one.
    1. Burcu Aydoğan & Ömür Uğur & Ümit Aksoy, 2023. "Optimal Limit Order Book Trading Strategies with Stochastic Volatility in the Underlying Asset," Computational Economics, Springer;Society for Computational Economics, vol. 62(1), pages 289-324, June.
    2. Philippe Bergault & David Evangelista & Olivier Gu'eant & Douglas Vieira, 2018. "Closed-form approximations in multi-asset market making," Papers 1810.04383, arXiv.org, revised Sep 2022.
    3. Philippe Bergault & Louis Bertucci & David Bouba & Olivier Gu'eant & Julien Guilbert, 2024. "Automated Market Making: the case of Pegged Assets," Papers 2411.08145, arXiv.org.
    4. Philippe Bergault & Louis Bertucci & David Bouba & Olivier Gu'eant, 2022. "Automated Market Makers: Mean-Variance Analysis of LPs Payoffs and Design of Pricing Functions," Papers 2212.00336, arXiv.org, revised Nov 2023.
    5. Philippe Bergault & Louis Bertucci & David Bouba & Olivier Guéant, 2024. "Automated market makers: mean-variance analysis of LPs payoffs and design of pricing functions," Digital Finance, Springer, vol. 6(2), pages 225-247, June.
    6. Spyros Galanis & Sergei Mikhalishchev, 2024. "Information Aggregation with Costly Information Acquisition," Papers 2406.07186, arXiv.org, revised Apr 2026.
    7. Jialiang Luo & Harry Zheng, 2021. "Dynamic Equilibrium of Market Making with Price Competition," Dynamic Games and Applications, Springer, vol. 11(3), pages 556-579, September.
    8. Philippe Bergault & Louis Bertucci & David Bouba & Olivier Gu'eant & Julien Guilbert, 2024. "Price-Aware Automated Market Makers: Models Beyond Brownian Prices and Static Liquidity," Papers 2405.03496, arXiv.org, revised May 2024.
    9. Jianjun Gao & Zizhuo Wang & Weiping Wu & Dian Yu, 2025. "Price Interpretability of Prediction Markets: A Convergence Analysis," Operations Research, INFORMS, vol. 73(1), pages 157-177, January.
    10. Hongzhou Chen & Xiaolin Duan & Abdulmotaleb El Saddik & Wei Cai, 2024. "Political Leanings in Web3 Betting: Decoding the Interplay of Political and Profitable Motives," Papers 2407.14844, arXiv.org.
    11. Mathieu Rosenbaum & Jianfei Zhang, 2022. "Multi-asset market making under the quadratic rough Heston," Papers 2212.10164, arXiv.org.
    12. Joseph Jerome & Gregory Palmer & Rahul Savani, 2022. "Market Making with Scaled Beta Policies," Papers 2207.03352, arXiv.org, revised Sep 2022.
    13. Frank M. V. Feys, 2026. "Avellaneda-Stoikov and Cartea-Jaimungal as One Framework: A Forced Uniqueness Theorem for Inventory Market Making," Papers 2606.01477, arXiv.org, revised Jun 2026.
    14. Marcello Monga, 2024. "Automated Market Making and Decentralized Finance," Papers 2407.16885, arXiv.org.
    15. Jonathan Ch'avez-Casillas & Jos'e E. Figueroa-L'opez & Chuyi Yu & Yi Zhang, 2024. "Adaptive Optimal Market Making Strategies with Inventory Liquidation Cos," Papers 2405.11444, arXiv.org.
    16. Majid Karimi & Stanko Dimitrov, 2024. "To Subsidize Or Not to Subsidize: A Comparison of Market Scoring Rules and Continuous Double Auctions for Price Discovery," Information Systems Frontiers, Springer, vol. 26(2), pages 801-823, April.
    17. Peter Cotton, 2026. "On a Simple Relationship Between Order Imbalance, Skew and Width in Over-The-Counter Trading," Papers 2608.07690, arXiv.org.
    18. Diego Zabaljauregui, 2020. "Optimal market making under partial information and numerical methods for impulse control games with applications," Papers 2009.06521, arXiv.org.
    19. Campi, Luciano & Zabaljauregui, Diego, 2020. "Optimal market making under partial information with general intensities," LSE Research Online Documents on Economics 104612, London School of Economics and Political Science, LSE Library.
    20. Karimi, Majid & Zaerpour, Nima, 2022. "Put your money where your forecast is: Supply chain collaborative forecasting with cost-function-based prediction markets," European Journal of Operational Research, Elsevier, vol. 300(3), pages 1035-1049.

    More about this item

    NEP fields

    This paper has been announced in the following NEP Reports:

    Statistics

    Access and download statistics

    Corrections

    All material on this site has been provided by the respective publishers and authors. You can help correct errors and omissions. When requesting a correction, please mention this item's handle: RePEc:arx:papers:2607.17991. See general information about how to correct material in RePEc.

    If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

    If CitEc recognized a bibliographic reference but did not link an item in RePEc to it, you can help with this form .

    If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your RePEc Author Service profile, as there may be some citations waiting for confirmation.

    For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: arXiv administrators (email available below). General contact details of provider: https://arxiv.org/ .

    Please note that corrections may take a couple of weeks to filter through the various RePEc services.

    IDEAS is a RePEc service. RePEc uses bibliographic data supplied by the respective publishers.