Dept. of Mathematics, LSE

We analyse the impact of market makers' risk aversion on the equilibrium in a speculative market consisting of a risk neutral informed trader and noise traders. The unwillingness of market makers to bear risk causes the informed trader to absorb large shocks in their inventories. The informed trader's optimal strategy is to drive the market price to its fundamental value while disguising her trades as the ones of an uninformed strategic trader. This results in a mean reverting demand, price reversal, and systematic changes in the market depth. We also find that an increase in risk aversion leads to lower market depth, less efficient prices, stronger price reversal and slower convergence to fundamental value. The endogenous value of private information, however, is non-monotonic in risk aversion. We will mainly concentrate on the case when the private signal of the informed is static. If time permits, the implications of a dynamic signal will be discussed as well.

Based on a joint work with Albina Danilova.