High frequency trading and asymptotics for small risk aversion in a Markov renewal model

TL;DR

This paper models high frequency trading within a Markov renewal framework, deriving explicit optimal controls and analyzing the impact of risk aversion, with practical approximations for small risk aversion levels.

Contribution

It introduces a semi-Markov model for high frequency trading, providing explicit solutions and a perturbation approach for small risk aversion, enhancing computational efficiency.

Findings

Explicit optimal controls in the no risk-aversion case

Characterization of the value function via linear PDE

Approximate controls for small risk aversion using simple PDEs

Abstract

We study a an optimal high frequency trading problem within a market microstructure model designed to be a good compromise between accuracy and tractability. The stock price is driven by a Markov Renewal Process (MRP), while market orders arrive in the limit order book via a point process correlated with the stock price itself. In this framework, we can reproduce the adverse selection risk, appearing in two different forms: the usual one due to big market orders impacting the stock price and penalizing the agent, and the weak one due to small market orders and reducing the probability of a profitable execution. We solve the market making problem by stochastic control techniques in this semi-Markov model. In the no risk-aversion case, we provide explicit formula for the optimal controls and characterize the value function as a simple linear PDE. In the general case, we derive the optimal controls and the value function in terms of the previous result, and illustrate how the risk aversion influences the trader strategy and her expected gain. Finally, by using a perturbation method, approximate optimal controls for small risk aversions are explicitly computed in terms of two simple PDE's, reducing drastically the computational cost and enlightening the financial interpretation of the results.