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Market makers’ optimal price-setting policy for exchange-traded certificates

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  • Baller, Stefanie
  • Entrop, Oliver
  • McKenzie, Michael
  • Wilkens, Marco

Abstract

This paper presents the first theoretical model of the profit maximizing price-setting policy for the issuers of exchange-traded retail certificates. Unlike previous theoretical microstructure models, the market considered is unique in that the market makers do not face significant inventory costs or risk from informed traders. The model derives the time structure of the optimal markups over a certificate’s fair theoretical value and its relationship with optimal spreads, unhedgeable risk faced by the issuer and investors’ buying and selling decisions. It shows that (i) the optimal markups decrease inter-temporally, (ii) issuers adjust the markups according to investors’ demand, (iii) unhedgeable risk results in higher markups and influences their time structure, (iv) the markups and the spread are negatively related. Using data from the German market for leverage certificates, we find strong empirical support for the model-derived hypotheses, except for (iv). We find spreads exhibit little variation and this suggests that markups and spreads are not substitute profit sources for issuers in this market.

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  • Baller, Stefanie & Entrop, Oliver & McKenzie, Michael & Wilkens, Marco, 2016. "Market makers’ optimal price-setting policy for exchange-traded certificates," Journal of Banking & Finance, Elsevier, vol. 71(C), pages 206-226.
    • Handle: RePEc:eee:jbfina:v:71:y:2016:i:c:p:206-226
    DOI: 10.1016/j.jbankfin.2016.04.012
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    Cited by:

    1. Baller, Stefanie & Entrop, Oliver & Schober, Alexander & Wilkens, Marco, 2017. "What drives performance in the speculative market of short-term exchange-traded retail products?," Passauer Diskussionspapiere, Betriebswirtschaftliche Reihe B-26-17, University of Passau, Faculty of Business and Economics.
    2. Entrop, Oliver & Fischer, Georg, 2019. "Hedging costs and joint determinants of premiums and spreads in structured financial products," Passauer Diskussionspapiere, Betriebswirtschaftliche Reihe B-34-19, University of Passau, Faculty of Business and Economics.
    3. Farkas, Miklós & Váradi, Kata, 2021. "Do leveraged warrants prompt individuals to speculate on stock price reversals?," Journal of Empirical Finance, Elsevier, vol. 63(C), pages 164-176.
    4. Oliver Entrop & Georg Fischer, 2020. "Hedging costs and joint determinants of premiums and spreads in structured financial products," Journal of Futures Markets, John Wiley & Sons, Ltd., vol. 40(7), pages 1049-1071, July.
    5. Ally Quan Zhang & Matthias Thul, 2017. "How much is the gap?—Efficient jump risk-adjusted valuation of leveraged certificates," Quantitative Finance, Taylor & Francis Journals, vol. 17(9), pages 1387-1401, September.

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    More about this item

    Keywords

    Structured products; Structured notes; Leverage certificates; Pricing behavior; Monopoly pricing model;
    All these keywords.

    JEL classification:

    • D40 - Microeconomics - - Market Structure, Pricing, and Design - - - General
    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing
    • G24 - Financial Economics - - Financial Institutions and Services - - - Investment Banking; Venture Capital; Brokerage

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