Robust Pricing under Strategic Trading

Abstract

We study strategic trading with a market maker who does not know the joint distribution of public information and an asset's value, and hence cannot interpret information properly. Following a public event, a probabilistic-ally informed trader who knows the distribution and liquidity traders trade. The market maker adopts a robust linear pricing strategy that has the best worst-case payoff guarantee. We show that such a strategy is equivalent to a two-step learning procedure, and characterize the unique linear equilibrium. Expected equilibrium prices exhibit under-reaction to public information. If the trading frequency is arbitrarily high, the market maker fully reveals the distribution in the price eventually.

Keywords: Ambiguity Aversion, Dynamic Strategic Trading, Price Drift, Under-reaction

JEL Classification: G14, D80