I'm reading the book "Financial Markets Under the Microscope" for my market microstructure studies. In the book, the variance of the market maker's gain is calculated as follows:

Assume that with probability $φ$, an arriving trade is informed, and correctly predicts a price jump of size $±J$. Otherwise (with probability $1 − φ$), the arriving trade is uninformed and does not predict a future price change. The variance $σ^2$ of the market-maker’s gain per trade is then given by

$σ^2 = (1 − φ) × 0 + φ × J^2$

But I calculate the variance as $σ^2 = φ × J^2 - φ^2 × J^2$ which is different from the book.

Do I miss something?

  • $\begingroup$ Ok I get what you are saying. You have basically put brackets around the second half of the equation and then expanded it out. Your calculations seem correct if the book left out brackets. Either the book forgot to put brackets in its equation or there is no (1-symbol I don’t have) because it is multiplied by 0 so the true equation you would be left with is ...symbol I don’t have * J^2... $\endgroup$ – JazKaz May 26 at 0:07

As I see it, a reasonable possibility is that it is a directional bet; money will only be made if the direction of the jump is correct, else the bet is lost.

So if the random outcome is $X \in \{-J, 0, J\}$ with

$\mathbb{P}(+J) = \mathbb{P}(-J) = \varphi /2 \;$ such that $\mathbb{P}(\pm J) = \varphi$,

then it follows that $\mathbb{E}[X] = 0$, and $\mathbb{V}[X] = \varphi \times J^2$. Q.E.D.

| improve this answer | |

Your Answer

By clicking “Post Your Answer”, you agree to our terms of service, privacy policy and cookie policy

Not the answer you're looking for? Browse other questions tagged or ask your own question.