Belief-Free Price Formation

Abstract:     
We analyze security price formation in a dynamic setting in which long-lived dealers repeatedly compete for trading with potentially informed retail traders. For a class of market microstructure models, we characterize equilibria in which dealers’ dynamic pricing strategies are optimal no matter the private information that each dealer has about the economy fundamentals. In a generalization of the Glosten and Milgrom model, these equilibria generate price dynamics that are reminiscent of well known stylized facts: price/trading-flow correlation, volatility clustering, price bubble and inventory/inter-dealer trading correlation.

Number of Pages in PDF File: 38

Keywords: Financial Market Microstructure, Belief-free Equilibria, Informed Market Makers, Price Volatility

JEL Classification: G1, G12, C72, C73

working papers series