Dynamic Multi-Factor Bid-Offer Adjustment Model: A Feedback Mechanism for Dealers (Market Makers) to Deal (Grapple) with the Uncertainty Principle of the Social Sciences

摘要

The author seeks to develop a model to alter the bid-offer spread, currentlyquoted by market makers, that varies with the market and trading conditions.The dynamic nature of financial markets and trading, as with the rest of socialsciences, where changes can be observed and decisions can be made byparticipants to influence the system, means that this model has to be adaptiveand include a feedback loop that alters the bid-offer adjustment based on themodifications observed in the market and trading conditions, without asignificant time delay. The factors used to adjust the spread are price volatility, which is publiclyobservable, and trade count and volume, which are generally known only to themarket maker, in various instruments over different historical durations intime. The contributions of each factor to the bid-offer adjustment are computedseparately and then consolidated to produce a very adaptive bid-offerquotation. The author uses the currency markets to build the sample modelbecause they are extremely liquid and trading in them is not as transparent asother financial instruments, such as equities. Simulating the number of tradesand the average size of trades from a lognormal distribution, the parameters ofthe lognormal distributions are chosen such that the total volume in a certaininterval matches the volume publicly mentioned by currency trading firms. Thismethodology can easily be extended to other financial instruments and possiblyto any product with the ability to make electronic price quotations, or caneven be used to periodically perform manual price updates on products that aretraded non-electronically.