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Ambiguous Market Making

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Abstract

This paper investigates the impact of informational ambiguity and attitude to it on security prices. Attention is focused on equilibria in which a market maker has an ambiguity in his probability assessment. We show that the equilibrium ambiguous bid-ask spread can be decomposed into the probabilistic spread and an “ambiguity premium/discount” component characterizing the ambiguity aversion/seeking of the market maker. In particular, for a sufficiently ambiguity averse market maker, the bid-ask spread widens with the informational ambiguity of the market maker, which provides an explanation to drying liquidity and price inefficiency during financial turmoils. An extension to different trade sizes shows that informed traders are more likely to trade large orders when there is a major ambiguous shock to the economy.

Suggested Citation

  • Nihad Aliyev & Xue-Zhong He, 2017. "Ambiguous Market Making," Research Paper Series 383, Quantitative Finance Research Centre, University of Technology, Sydney.
    • Handle: RePEc:uts:rpaper:383
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    File URL: https://www.uts.edu.au/sites/default/files/article/downloads/QFR-rp383.pdf
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    References listed on IDEAS

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    More about this item

    Keywords

    market microstructure; informational ambiguity; Choquet expectation; generalized Bayesian updating; non-additive probability;
    All these keywords.

    JEL classification:

    • G14 - Financial Economics - - General Financial Markets - - - Information and Market Efficiency; Event Studies; Insider Trading
    • D81 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Criteria for Decision-Making under Risk and Uncertainty
    • D82 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Asymmetric and Private Information; Mechanism Design

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