Robust Market Making
Seminar Room 2, Newton Institute Gatehouse
AbstractCo-authors: Alvaro (Cartea), Ryan (Donnelly)
Because market makers (MMs) acknowledge that their models are incorrectly specified, in this paper, we allow for ambiguity in their choices to make their models robust to misspecification in (i) the arrival rate of market orders (MOs), (ii) the fill probability of limit orders, and (iii) the dynamics of the fundamental value of the asset they deal. We demonstrate that MMs adjust their quotes to reduce inventory risk and adverse selection costs. Moreover, robust market making increases the Sharpe ratio of market making strategies and allows for the MM to fine tune the tradeoff between the mean and the standard deviation of expected profits. Our framework adopts the robust optimal control approach of Hansen and Sargent (2007) and we provide analytical solutions for the robust optimal strategies as well as a verification theorem. We also find that in many circumstances ambiguity averse MMs act differently from MMs who are risk averse.