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A Model of Market Making and Price Impact

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  • Angad Singh

Abstract

Traders constantly consider the price impact associated with changing their positions. This paper seeks to understand how price impact emerges from the quoting strategies of market makers. To this end, market making is modeled as a dynamic auction using the mathematical framework of Stochastic Differential Games. In Nash Equilibrium, the market makers' quoting strategies generate a price impact function that is of the same form as the celebrated Almgren-Chriss model. The key insight is that price impact is the mechanism through which market makers earn profits while matching their books. As such, price impact is an essential feature of markets where flow is intermediated by market makers.

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  • Angad Singh, 2021. "A Model of Market Making and Price Impact," Papers 2101.01388, arXiv.org.
    • Handle: RePEc:arx:papers:2101.01388
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    References listed on IDEAS

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    1. Robert Wilson, 1979. "Auctions of Shares," The Quarterly Journal of Economics, President and Fellows of Harvard College, vol. 93(4), pages 675-689.
    2. Back, Kerry E., 2017. "Asset Pricing and Portfolio Choice Theory," OUP Catalogue, Oxford University Press, number 9780190241148.
    3. Foucault, Thierry & Pagano, Marco & Roell, Ailsa, 2013. "Market Liquidity: Theory, Evidence, and Policy," OUP Catalogue, Oxford University Press, number 9780199936243.
    4. Lasse Heje Pedersen, 2015. "Efficiently Inefficient: How Smart Money Invests and Market Prices Are Determined," Economics Books, Princeton University Press, edition 1, number 10441.
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