Ambiguous Price Formation

57 Pages Posted: 27 Dec 2016 Last revised: 16 Nov 2018

See all articles by Nihad Aliyev

Nihad Aliyev

University of Technology Sydney (UTS) - School of Finance and Economics

Xuezhong He

University of Technology Sydney (UTS) - Finance Discipline Group, Business School; Financial Research Network (FIRN)

Date Written: November 2018

Abstract

Markets often experience liquidity deteriorations during financial crisis and improvements during reforms in trading rules. To explain these phenomena, we present a price formation model in which market makers are subject to ambiguity. When the market maker is sufficiently ambiguity averse, the illiquidity naturally arises in ambiguous market episodes due to the increased perceived adverse selection risk. Ambiguity can also improve liquidity when the market maker is insufficiently ambiguity averse. Consequently, the liquidity improvements can increase the value of information to informed traders and welfare to society. Furthermore, the presence of ambiguity leads the informed traders to trade large quantities.

Keywords: Market microstructure, ambiguity, ambiguity aversion, liquidity, value of information, welfare

JEL Classification: G14, D4, D81, D82

Suggested Citation

Aliyev, Nihad and He, Xue-Zhong 'Tony', Ambiguous Price Formation (November 2018). Available at SSRN: https://ssrn.com/abstract=2890117 or http://dx.doi.org/10.2139/ssrn.2890117

Nihad Aliyev (Contact Author)

University of Technology Sydney (UTS) - School of Finance and Economics ( email )

Haymarket
Sydney, NSW 2007
Australia

Xue-Zhong 'Tony' He

University of Technology Sydney (UTS) - Finance Discipline Group, Business School ( email )

Haymarket
Sydney, NSW 2007
Australia

Financial Research Network (FIRN)

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

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

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