ASSIGNMENT

Preparation Questions for Market Making Simulation

1. Suppose you are a market maker who currently has no net position in a security that is currently valued at $10.  In one day, you expect the security's fair value to be either $9, $10, or $11, all with equal probability.  If tomorrow's price will be $10, you can expect to face a liquidity trader today who will buy or sell one share from you with equal probability.  If, on the other hand, the value changes tomorrow to $11 or $9, you will face an informed trader today, who knows tomorrow's value.  This informed trader will purchase one share from you if the value will be $11 and sell one share to you if the value will be $9.  Whatever position you have by the end of today, you expect to be able to exit at tomorrow's fair value.  If you set a bid-ask mid-price of $10 today, how small a bid-ask spread can you set and still expect to break even? Assume that as a market maker you do not earn a spread on the sale or acquisition of the security in day two (i.e. securities are valued at market-to-market; no transaction occurs).

2. In the basic classroom simulation described in the Price Formation Module Overview, what is fair value for one of five exclusive market making rights that are good for five minutes?  How does this value change if the number of rights is fifteen?  

3. How much would you pay to know the price of a given stock in one week's time?  What factors influence your willingness to pay?  How would your payoffs look for different realizations of the signal?  

4. If no computer liquidity traders populate the market, what do you expect will happen to spreads?  How will the value of market making rights change?  What will happen to the frequency of information purchases and to price efficiency?