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Enron Mail |
Vince, Over the weekend, I fomulated the idea using option pricing for the EOL price seeting rules. The initial results look interesting. I will write it up for your inputs. Also attach is the program SnagIt, for printing window. Zimin -------------------- main idea ------------------------------ A market maker fulfills the obligation to provide liquidity, therefore he should be compensated for his service. In the option langauge, the market maker sells options to the traders, for a market order to buy, the market maker has to sell at the ask price and for a market order to sell, the market maker has to buy at the bid price. When the ask price is hit the trader exercised a call option against the market maker, when the bid price is lifted, the trader exercised a put. The option premium that the traders paid to the market maker is implicitly embedded in the bid-ask spread. There is a capital requirement for the market making. In a rising (falling) market, the market maker will accumulate a net short (long) position. There are two kind of costs. The first is associated to carry the market-to-market(MTM) value to the next period. The market maker needs to charge a risk-free interest for the carrying the inventory to the next period. The second is the charge for the risk capital. If the ask (bid) were hit (lifted) in a rising (falling) market, the market maker would realized a loss reflecting the MTM change. Thus, the risk capital that the market maker laid aside is the amount of money that he is prepared to lose, in exchange for some return. The risk adjusted return on capital or RAROC rate reflects the risk attitude of the market maker in providing the liquid to the market participants. In balance, the market maker sells options to compensate his costs in provide market liquidity. From this train of thoughts, I derive a formula for the bid and ask prices as function of the last executed price, inventory level, price volatility, trade size, order arrival rate, risk-free interest rate and RAROC rate. The limit orders are not considered here, since there are very few limit orders traded on EnronOnLine (EOL).
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