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We study a stock dealer’s strategy for submitting bid and ask quotes in a limit order book. The agent faces an inventory risk due to the diffusive nature of the stock’s mid-price and a transactions risk due to a Poisson arrival of market buy and sell orders. After setting up the agent’s problem in a maximal expected utility framework, we derive the solution in a two step procedure. First, the dealer computes a personal indifference valuation for the stock, given his current inventory. Second, he calibrates his bid and ask quotes to the market’s limit order book. We compare this ”inventory-based ” strategy to a ”naive ” best bid/best ask strategy by simulating stock price paths and displaying the P&L profiles of both strategies. We find that our strategy has a P&L profile that has both a higher return and lower variance than the benchmark strategy. 1
Authors: Marco Avellaneda, Sasha Stoikov
Citations: 499
Published: 2008-03-29T00:00:00.000Z
Venue: Quantitative Finance. Year: 2008. Citations: 499. Abstract signal: We study a stock dealer’s strategy for submitting bid and ask quotes in a limit order book. The agent faces an inventory risk due to the diffusive nature of the stock’s mid-price and a transactions risk due to a Poisson...
We study a stock dealer’s strategy for submitting bid and ask quotes in a limit order book. The agent faces an inventory risk due to the diffusive nature of the stock’s mid-price and a transactions risk due to a Poisson arrival of market buy and sell orders. After setting up the agent’s problem in a maximal expected utility framework, we derive the solution in a two step procedure. First, the dealer computes a personal indifference valuation for the stock, given his current inventory. Second, he calibrates his bid and ask quotes to the market’s limit order book. We compare this ”inventory-based ” strategy to a ”naive ” best bid/best ask strategy by simulating stock price paths and displaying the P&L profiles of both strategies. We find that our strategy has a P&L profile that has both a higher return and lower variance than the benchmark strategy. 1
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