Optimal market making

TL;DR

This paper introduces a comprehensive framework for optimal market making, providing new theoretical insights, closed-form solutions, and practical applications for multi-asset scenarios including credit indices.

Contribution

It generalizes existing models, proves new results on strategy existence, and offers practical approximations for multi-asset market making strategies.

Findings

New general results on optimal strategies

Closed-form approximations for quotes

Application to credit indices

Abstract

Market makers provide liquidity to other market participants: they propose prices at which they stand ready to buy and sell a wide variety of assets. They face a complex optimization problem with both static and dynamic components. They need indeed to propose bid and offer/ask prices in an optimal way for making money out of the difference between these two prices (their bid-ask spread). Since they seldom buy and sell simultaneously, and therefore hold long and/or short inventories, they also need to mitigate the risk associated with price changes, and subsequently skew their quotes dynamically. In this paper, (i) we propose a general modeling framework which generalizes (and reconciles) the various modeling approaches proposed in the literature since the publication of the seminal paper "High-frequency trading in a limit order book" by Avellaneda and Stoikov, (ii) we prove new general results on the existence and the characterization of optimal market making strategies, (iii) we obtain new closed-form approximations for the optimal quotes, (iv) we extend the modeling framework to the case of multi-asset market making and we obtain general closed-form approximations for the optimal quotes of a multi-asset market maker, and (v) we show how the model can be used in practice in the specific (and original) case of two credit indices.