Optimal Bid-Ask Spread in Limit-Order Books under Regime Switching Framework

Farzad Alavi Fard ()
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Farzad Alavi Fard: School of Economics, Finance and Marketing, RMIT University, 445 Swanson Street, Melbourne, VIC 3000, AUSTRALIA

Review of Economics & Finance, 2014, vol. 4, 33-48

Abstract: This paper advocates a regime-switching model to capture the risk of structural changes in the economy, when determining the optimal bid-ask spread in limit order books. In our model, the market-maker faces an inventory risk due to the diffusive nature of the stocks¡¯ mid-price and a transactions risk due to a Poisson arrival of market ¡°buy¡± and ¡°sell¡± orders. We propose that the intensity of the orders depend on the state of the economy, and in the event of a structural change, market makers will face different intensity of order flows, reflecting the new market conditions. In our model, the dealer is a wealth maximizing agent who dynamically manages his portfolio. We employ Hamilton-Jacobi-Bellman equation for the dynamic programming problem, and we solve the problem numerically using the Galerkin method.

Keywords: Market micro-structure; Limit-order; Regime switching; HJB; Galerkin method (search for similar items in EconPapers)
JEL-codes: C02 C61 D43 D58 G11 (search for similar items in EconPapers)
Date: 2014
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Citations: View citations in EconPapers (2)

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