Optimal Market Making in the Presence of Latency
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AbstractThis paper studies optimal market making for large-tick assets in the presence of latency. We consider a random walk model for the asset price and formulate the market maker's optimization problem using Markov Decision Processes (MDP). We characterize the value of an order and show that it plays the role of one-period reward in the MDP model. Based on this characterization, we provide explicit criteria for assessing the profitability of market making when there is latency. Under our model, we show that a market maker can earn a positive expected profit if there are sufficient uninformed market orders hitting the market maker's limit orders compared with the rate of price jumps, and the trading horizon is sufficiently long. In addition, our theoretical and numerical results suggest that latency can be an additional source of risk and latency impacts negatively the performance of market makers.
Acceptance Date06/03/2020
All Author(s) ListGAO Xuefeng, WANG Yunhan
Journal nameQuantitative Finance
Year2020
Month4
Day20
Volume Number20
Issue Number9
PublisherRoutledge
Pages1495 - 1512
ISSN1469-7688
eISSN1469-7696
LanguagesEnglish-United Kingdom
KeywordsLarge-tick assets, Limit order book, Market making, Markov decision process, Order value