Price-Setting of Market Makers: A Filtering Problem with an Endogenous Filtration

TL;DR

This paper rigorously analyzes how market makers set prices in a continuous-time model where they filter noisy information about an asset's true value, which is observed intermittently by customers, using a filtering approach with endogenous filtration.

Contribution

It introduces a novel filtering framework with endogenous filtration to model market makers' price-setting, establishing existence and uniqueness of the resulting price processes.

Findings

Existence and uniqueness of price processes under certain conditions

Mathematically rigorous solution to the filtering problem

Extension of classic market microstructure models

Abstract

We study the price-setting problem of market makers under risk neutrality and perfect competition in continuous time. Thereby we follow the classic Glosten-Milgrom model that defines bid and ask prices as expectations of a true value of the asset given the market makers' partial information that includes the customers trading decisions. The true value is modeled as a Markov process that can be observed by the customers with some noise at Poisson times. We analyze the price-setting problem in a mathematically rigorous way by solving a filtering problem with an endogenous filtration that depends on the bid and ask price process quoted by the market maker. Under some conditions we show existence and uniqueness of the price processes.