Market Making with Fads, Informed, and Uninformed Traders

TL;DR

This paper models a market making problem considering short-term asset price deviations called fads, analyzing how informed and uninformed traders impact liquidity and how the market maker can optimally respond under different information scenarios.

Contribution

It introduces a continuous-time model incorporating fads and trader types, characterizes optimal strategies, and explores information extraction beyond standard filtering methods.

Findings

Price of liquidity depends on the proportion of informed traders.

The value of information is explicitly characterized.

Methods to extract fad information from market data are proposed.

Abstract

We characterise the solutions to a continuous-time optimal liquidity provision problem in a market populated by informed and uninformed traders. In our model, the asset price exhibits fads -- these are short-term deviations from the fundamental value of the asset. Conditional on the value of the fad, we model how informed traders and uninformed traders arrive in the market. The market maker knows of the two groups of traders but only observes the anonymous order arrivals. We study both, the complete information and the partial information versions of the control problem faced by the market maker. In such frameworks, we characterise the value of information, and we find the price of liquidity as a function of the proportion of informed traders in the market. Lastly, for the partial information setup, we explore how to go beyond the Kalman-Bucy filter to extract information about the fad from the market arrivals.