Market Making with Model Uncertainty

TL;DR

This paper interprets pari-mutuel market clearing as a form of ambiguity-averse market making and introduces a new efficient algorithm called the Knightian Pari-mutuel Mechanism that explicitly accounts for model uncertainty.

Contribution

It provides a novel economic interpretation of pari-mutuel markets as ambiguity-averse market makers and develops a new polynomial-time market-clearing algorithm called KPM.

Findings

Equivalence between pari-mutuel auctioneer and ambiguity-averse market maker.

KPM retains key properties of pari-mutuel markets.

KPM is computationally efficient, solvable in polynomial time.

Abstract

Pari-mutuel markets are trading platforms through which the common market maker simultaneously clears multiple contingent claims markets. This market has several distinctive properties that began attracting the attention of the financial industry in the 2000s. For example, the platform aggregates liquidity from the individual contingent claims market into the common pool while shielding the market maker from potential financial loss. The contribution of this paper is two-fold. First, we provide a new economic interpretation of the market-clearing strategy of a pari-mutuel market that is well known in the literature. The pari-mutuel auctioneer is shown to be equivalent to the market maker with extreme ambiguity aversion for the future contingent event. Second, based on this theoretical understanding, we present a new market-clearing algorithm called the Knightian Pari-mutuel Mechanism (KPM). The KPM retains many interesting properties of pari-mutuel markets while explicitly controlling for the market maker's ambiguity aversion. In addition, the KPM is computationally efficient in that it is solvable in polynomial time.