Dynamic Multi-Factor Bid-Offer Adjustment Model - Visual Version
Institutional Investor Journals, Journal of Trading, Vol. 9, No. 3 (Summer 2014), pp. 42-55
17 Pages Posted: 1 May 2014 Last revised: 21 Jan 2015
Date Written: April 20, 2014
The objective is to come up with a model that alters the Bid-Offer, currently quoted by market makers, that varies with the market and trading conditions. The dynamic nature of financial markets and trading, as the rest of social sciences, where changes can be observed and decisions can be taken by participants to influence the system, means that our model has to be adaptive and include a feedback loop that alters the bid offer adjustment based on the modifications we are seeing in the market and trading conditions, without a significant time delay. We will build a sample model that incorporates such a feedback mechanism and also makes it possible to check the efficacy of the changes to the quotes being made, by gauging the impact on the Profits.
The market conditions here refer to factors that are beyond the direct control of the market maker and this information is usually available publicly to other participants. Trading conditions refer to factors that can be influenced by the market maker and are dependent on the trading book being managed and will be privy only to the market maker and will be mostly confidential to others. The factors we use to adjust the spread are the price volatility, which is publicly observable; and trade count and volume, which are generally only known to the market maker, in various instruments over different historical durations in time. The contributions of each of the factors to the bid-offer adjustment are computed separately and then consolidated to produce a very adaptive bid-offer quotation. The ensuing discussion considers the calculations for each factor separately and the consolidation in detail.
Any model that automatically updates the quotes is more suited for instruments that have a high number of transactions within short intervals, making it hard for traders to manually monitor and adjust the spread; though this is by no means a stringent requirement. We can use similar models for illiquid instruments as well and use the quotations provided by the model as a baseline for further human refinement.
We have chosen the currency markets to build the sample model since they are extremely liquid, Over the Counter (OTC), and hence trading in them is not as transparent as other financial instruments like equities. The nature of currency trading implies that we do not have any idea on the actual volumes traded and the number of trades. We simulate the number of trades and the average size of trades from a log normal distribution. The parameters of the log normal distributions are chosen such that the total volume in a certain interval matches the volume publicly mentioned by currency trading firms. This methodology can be easily extended to other financial instruments and possibly to any product with an ability to make electronic price quotations or even be used to periodically perform manual price updates on products that are traded non-electronically.
Thankfully, we are not at a stage where Starbucks will sell coffee using such an algorithm, since it can possibly lead to certain times of the day when it can be cheaper to have a cup of coffee and as people become wary of this, there can be changes to their buying habits, with the outcome that the time for getting a bargain can be constantly changing; making the joys of sipping coffee, a serious decision making affair.
Keywords: Dynamic, Model, Bid, Offer, Ask, Volatility, Standard, Deviation, Quote, Feedback, Loop, Currency, Foreign, Exchange, Adjust, Change, Factor, Variable, Multi, Dealer, Spread, Risk, Uncertainty, Principle, Social, Science, Market, Maker, Deal
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