Market Makers’ Optimal Price-Setting Policy for Exchange-Traded Certificates

Posted: 5 Dec 2014 Last revised: 25 Jul 2016

See all articles by Stefanie Baller

Stefanie Baller

University of Passau

Oliver Entrop

University of Passau

Michael D. McKenzie

The University of Sydney - Discipline of Finance; University of Cambridge - Cambridge Endowment for Research in Finance (CERF); Financial Research Network (FIRN)

Marco Wilkens

University of Augsburg

Date Written: 2016

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.

Keywords: Structured Products, Structured Notes, Leverage Certificates, Pricing Behavior, Monopoly Pricing Model

JEL Classification: D40, G13, G24

Suggested Citation

Baller, Stefanie and Entrop, Oliver and McKenzie, Michael David and Wilkens, Marco, Market Makers’ Optimal Price-Setting Policy for Exchange-Traded Certificates (2016). Journal of Banking and Finance, Vol. 71, 2016, 206-226. Available at SSRN: https://ssrn.com/abstract=2377795 or http://dx.doi.org/10.2139/ssrn.2377795

Stefanie Baller

University of Passau ( email )

Innstrasse 27
Passau, 94032
Germany

Oliver Entrop (Contact Author)

University of Passau ( email )

Innstrasse 27
Passau, 94032
Germany
+49 851 509 2460 (Phone)
+49 851 509 2462 (Fax)

Michael David McKenzie

The University of Sydney - Discipline of Finance ( email )

Level 2 9 Castlereagh Street
Sydney, NSW 2000
Australia
+61 2 9114 0578 (Phone)
+61 2 9351 6461 (Fax)

University of Cambridge - Cambridge Endowment for Research in Finance (CERF) ( email )

Trumpington Street
Cambridge, CB2 1AG
United Kingdom

Financial Research Network (FIRN)

C/- University of Queensland Business School
St Lucia, 4071 Brisbane
Queensland
Australia

HOME PAGE: http://www.firn.org.au

Marco Wilkens

University of Augsburg ( email )

Universitaetsstr. 16
Augsburg, 86159
Germany
+49 821 598 4124 (Phone)
+49 821 598 4223 (Fax)

HOME PAGE: http://www.wiwi.uni-augsburg.de/bwl/wilkens/team/wilkens_marco/

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