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

Carlos Ulibarri, Peter C. Anselmo, Karen Hovespian, Jacob Tolk and Ionut Florescu
Additional contact information
Peter C. Anselmo: Department of Management, New Mexico Institute of Mining and Technology, USA, Postal: Department of Management, New Mexico Institute of Mining and Technology, USA
Karen Hovespian: Department of Management, New Mexico Institute of Mining and Technology, USA, Postal: Department of Management, New Mexico Institute of Mining and Technology, USA
Jacob Tolk: Department of Management, New Mexico Institute of Mining and Technology, USA, Postal: Department of Management, New Mexico Institute of Mining and Technology, USA
Ionut Florescu: Department of Mathematical Sciences, Stevens Institute of Technology, USA, Postal: Department of Mathematical Sciences, Stevens Institute of Technology, USA

International Journal of Finance & Economics, 2009, vol. 14, issue 3, 268-279

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 © 2008 John Wiley & Sons, Ltd.

Date: 2009
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Journal Article: 'Noise-trader risk' and Bayesian market making in FX derivatives: rolling loaded dice? (2009)
Working Paper: 'Noise trader risk' and Bayesian market making in FX derivatives: rolling loaded dice? (2008)
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DOI: 10.1002/ijfe.373

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