Optimal Market Making in the Chinese Stock Market: A Stochastic Control and Scenario Analysis

TL;DR

This paper develops an optimal market making model tailored for the Chinese stock market, incorporating key risks and market conditions, and provides insights on how factors like volatility and stamp duty influence market making performance.

Contribution

It introduces a stochastic control framework with an exponential utility function that captures major risks and market conditions specific to China, filling a research gap.

Findings

Stamp duty negatively affects market maker profit and liquidity.

Volatility impacts inventory management and risk exposure.

Accurate drift estimation improves market making strategies.

Abstract

Market making plays a crucial role in providing liquidity and maintaining stability in financial markets, making it an essential component of well-functioning capital markets. Despite its importance, there is limited research on market making in the Chinese stock market, which is one of the largest and most rapidly growing markets globally. To address this gap, we employ an optimal market making framework with an exponential CARA-type (Constant Absolute Risk Aversion) utility function that accounts for various market conditions, such as price drift, volatility, and stamp duty, and is capable of describing 3 major risks (i.e., inventory, execution and adverse selection risks) in market making practice, and provide an in-depth quantitative and scenario analysis of market making in the Chinese stock market. Our numerical experiments explore the impact of volatility on the market maker's inventory. Furthermore, we find that the stamp duty rate is a critical factor in market making, with a negative impact on both the profit of the market maker and the liquidity of the market. Additionally, our analysis emphasizes the significance of accurately estimating stock drift for managing inventory and adverse selection risks effectively and enhancing profit for the market maker. These findings offer valuable insights for both market makers and policymakers in the Chinese stock market and provide directions for further research in designing effective market making strategies and policies.