Lin, Hao (2006) Essays in market microstructure. PhD thesis, University of Warwick.

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Abstract

Market making is central to the study of market microstructure. Market makers stand ready to
provide liquidity, market stability and price discovery, issues of great importance to regulators,
practitioners and academics. This thesis contributes to the literature by studying four topical issues
related to market making.
The thesis consists of four essays. In the first essay we develop a simple multi-period model
of market making for a monopolistic stock market maker. The market maker tries to solve simultaneously
the problems of managing his inventory and trading with informed traders. He uses a
Kalman filter to update his estimates of the unknown market prices through his noisy order flow
observation. We analytically characterize the optimal bid and ask prices and find that they depend
on the beginning inventory, the estimated price, and the market maker's prior estimation error of the
price process for each time period. We obtain desirable numerical results by using properly chosen
parameters. The extensions to the continuous time and a competitive market making environment
are also discussed.
The second essay extends the model in the first essay to consider the market making of multiple
stocks. The market maker still does not know the true prices but is assumed to know the return
covariance structure of these stocks. When the market maker considers the correlated order flow
information, his knowledge of the return covariance improves his estimation of the unknown price
processes, resulting in higher cumulative profits and lower risks of the profits.
The third essay analyzes the effect of option market makers' hedging on the informed trading
strategy and the subsequent changes in the costs of liquidity provision in both stock and option
markets. In a sequential trading framework, an option market maker uses the stock market to hedge
his option position. His hedging trade affects the way that informed traders submit their orders in
both the stock and the option market, which in turn changes the informed trading pressure faced
by the market makers in each market. Furthermore, information in the option trading is passed to
the stock market through the hedging trade. Both stock and option spreads are wider with option
market maker's hedging. The increase in the spreads is more significant when the option market
maker hedges in the underlying market than when it hedges with different options.
The fourth essay provides a model of bookmaking in a horse race betting market. The bookmaker
observes the noisy public betting flow and faces the risk of trading with possible informed traders,
as well as the risk of his unbalanced liability exposures. Even the noisy demand can unbalance the
bookmaker's book. In our model, the bookmaker revises his odds to mitigate the risk. Allowing
the bookmaker to set odds over several rounds of betting gives a clear view of the bookmaker's
price setting strategy and its impact on the public betting flow over time. The study of horse
race bookmaking provides useful insights into the market making of state contingent claims such as
options.

Item Type:	Thesis (PhD)
Subjects:	H Social Sciences > HG Finance
Library of Congress Subject Headings (LCSH):	Finance, Stock exchanges -- Mathematical models, Options (Finance) -- Mathematical models, Book-making (Betting) -- Mathematical models
Official Date:	July 2006
Dates:	Date Event July 2006 Submitted
Institution:	University of Warwick
Theses Department:	Warwick Business School
Thesis Type:	PhD
Publication Status:	Unpublished
Supervisor(s)/Advisor:	Hodges, Stewart D.
Sponsors:	University of Warwick ; University of Wisconsin-Madison ; Warwick Business School
Extent:	x, 205 leaves
Language:	eng

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