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

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  • Ulibarri, Carlos A.
  • Anselmo, Peter
  • Hovsepian, Karen
  • Florescu, Ionut
  • Tolk, Jacob

Abstract

ABSTRACT 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 r 2008 John Wiley & Sons, Ltd. Copyright r 2008 John Wiley & Sons, Ltd.

Suggested Citation

  • Ulibarri, Carlos A. & Anselmo, Peter & Hovsepian, Karen & Florescu, Ionut & Tolk, Jacob, 2008. "'Noise trader risk' and Bayesian market making in FX derivatives: rolling loaded dice?," MPRA Paper 14814, University Library of Munich, Germany.
  • Handle: RePEc:pra:mprapa:14814
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    References listed on IDEAS

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    Cited by:

    1. Stan Miles, 2013. "Constant-collateral pyramiding trading strategies in futures markets," Financial Markets and Portfolio Management, Springer;Swiss Society for Financial Market Research, vol. 27(4), pages 381-396, December.

    More about this item

    Keywords

    Noise trading; market making; FX derivatives; Bayesian agent; noise transmission;

    JEL classification:

    • G14 - Financial Economics - - General Financial Markets - - - Information and Market Efficiency; Event Studies; Insider Trading
    • G15 - Financial Economics - - General Financial Markets - - - International Financial Markets
    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing

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