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

Carlos Ulibarri, Peter Anselmo, Karen Hovsepian, Ionut Florescu and Jacob Tolk

MPRA Paper from University Library of Munich, Germany

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.

Keywords: Noise trading; market making; FX derivatives; Bayesian agent; noise transmission (search for similar items in EconPapers)
JEL-codes: G13 G14 G15 (search for similar items in EconPapers)
Date: 2008
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Related works:
Journal Article: 'Noise-trader risk' and Bayesian market making in FX derivatives: rolling loaded dice? (2009)
Journal Article: 'Noise-trader risk' and Bayesian market making in FX derivatives: rolling loaded dice? (2009)
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