Market Makers and Risk Aversion: A Hamiltonian Approach to the Excess Volatility Puzzle

TL;DR

This paper models financial market chaos using nonlinear oscillators, showing that unpredictable price changes can occur without external shocks, driven instead by market makers' risk appetite.

Contribution

It introduces a Hamiltonian framework modeling market dynamics as anharmonic oscillators with nonlinear coupling, highlighting the intrinsic sources of market volatility.

Findings

Market chaos depends on market makers' risk appetite.

Unpredictable prices can arise without external shocks.

Nonlinear oscillator models capture market dynamics effectively.

Abstract

In this article we model chaotic dynamics in financial markets by treating the market price, and market makers' inventory, as anharmonic oscillators with a nonlinear coupling. The market makers' risk appetite being the key parameter that determines the degree of chaos in the system. The article demonstrates that whilst external shocks and random noise are important in the treatment of financial time-series, they are not necessary in order to generate unpredictable price changes.