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‘Noise‐trader risk’ and Bayesian market making in FX derivatives: rolling loaded dice?
Author(s) -
Ulibarri Carlos A.,
Anselmo Peter C.,
Hovespian Karen,
Tolk Jacob,
Florescu Ionut
Publication year - 2009
Publication title -
international journal of finance and economics
Language(s) - English
Resource type - Journals
SCImago Journal Rank - 0.505
H-Index - 39
eISSN - 1099-1158
pISSN - 1076-9307
DOI - 10.1002/ijfe.373
Subject(s) - futures contract , economics , volatility (finance) , derivatives market , financial economics , econometrics , martingale (probability theory) , arbitrage , bayesian probability , computer science , mathematics , statistics , artificial intelligence
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.