Chapter 11. Trading on Market Microstructure: Information Models

Inventory models, discussed in Chapter 10, propose ways in which a market maker can set limit order prices based on characteristics of the market maker such as inventory (limit order book) and risk preferences. As such, inventory models do not account for motivations of other market participants. The dynamics relating to the trading rationale and actions of other market participants, however, can significantly influence the market maker's behavior.

Information models specifically address the intent and future actions of various market participants. Information models include game-theoretic approaches to reverse-engineer quote and trade flows to discover the information a market maker possesses. Information models also use observed or inferred order flow to make informed trading decisions.

At their core, information models describe trading on information flow and possible informational asymmetries arising during the dissemination of information. Differences in information flow persist in different markets. Information flow is comparably faster in transparent centralized markets, such as most equity markets and electronic markets, and slower in the opaque markets, such as foreign exchange and OTC markets in bonds and derivatives.

The main outcome of information models is that the bid-ask spreads persist even when the market maker has unlimited inventory and is able to absorb any trading request instantaneously. In fact, ...

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