Market Maker’s Dilemma

<body bgcolor="#E8FFF0"> <div align="left"> <table border="0" cellpadding="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" id="table16"> <tr> <td width="740"> <table border="0" cellpadding="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" height="37" id="table17"> <tr> <td height="35" width="100%"> <table border="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" cellpadding="0" id="table18"> <tr> <td> <p align="center" class="header_green"><map name="FPMap4"> <area target="5" href="../../blog_071010_post.htm" shape="rect" coords="0, 0, 149, 29"> </map>Market Maker’s Dilemma</td> </tr> </table> </td> </tr> <tr> <td width="100%" bgcolor="#CC9966" height="2"> <img border="0" src="../../../images/blank_2x2.gif" width="2" height="2"></td> </tr> <tr> <td width="0%" valign="top" bgcolor="#FFFFCC"> <table border="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" cellpadding="0" id="table19"> <tr> <td align="left" valign="top" bgcolor="#E8FFF0"> <p class="blog_body" align="center"> October 10, 2007  <font size="2"> <a target="_top" href="http://www.glynholton.com/link/blog_071010.htm">permalink</a></font>  <a target="5" href="../../blog_071010_post.htm"> comment</a>  <a href="mailto:glyn@contingencyanalysis.com?subject=Blog Feedback"> e-mail</a></td> </tr> </table> </td> </tr> </table> <p class="blog_body">One of my clients is a bunker fuel distributor. They source various grades of oil, blend them into bunker fuel, and sell it to ships in ports around the world. Each port is its own market. In some ports, my client is a two-bit player. In others, it is the market maker. In those ports, they largely set the price of bunker. Unlike a price taker, who tends to pay more when supply is short, they can influence prices to benefit themselves. When they have excess supply in a port, they can sometimes increase the price to make a profit. When their supply is low, and competitors are selling more, they try to drive the price down. </p> <p class="blog_body">What does this mean for value-at-risk (VaR)? Risk is exposure to uncertainty. VaR quantifies market risk by treating volatility as a proxy for uncertainty. For your typical price taker, this is fine, but not for a market maker. If market makers drive prices up or down to benefit themselves, there is nothing uncertain about the resulting volatility—at least not for them. The volatility isn’t a risk for them so much as a way of doing business. It is kind of pointless calculating VaR for them based on the market volatility they created! </p> <p class="blog_body">When we "measure" risk, we aren't really measuring risk. We are measuring some proxy for risk, such as value-at-risk, portfolio volatility or fatalities per passenger-mile. Sometimes a proxy used by others isn't so useful for us. This is the situation my client is in. </p> <p class="blog_body">Market makers face their own set of risks related to liquidity and informational asymmetry. These aren't such a problem for my bunker fuel client, since theirs is not a leveraged market. Such problems are more significant for market makers in the capital markets, where leverage abounds. In the capital markets, every time a market maker quotes a large transaction for a sophisticated counterparty, she has to wonder "what does he know that I don't?" The very fact that the knowledgeable counterparty wants to put on the trade increases the likelihood that the trade will move against the market maker. VaR doesn't recognize this either. </p> <p class="blog_body">If VaR is a poor proxy for trading risks faced by market makers, why do the Basel Accords embrace VaR as their proxy for measuring risk in bank's trading books? After all, many market makers are banks. The answer seems to be that no one has ever devised an effective proxy for the trading risks of market makers. It is easy to criticize what exists—people criticize VaR all the time. It is more difficult to come up with something better. Until we do come up with something better, I suspect the typical CEO of a market making firm would prefer a daily VaR report over nothing.</p> <p class="blog_body" align="center"> Glyn A. Holton</p> <table border="0" cellpadding="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" height="37" id="table20"> <tr> <td height="35" width="100%"> <table border="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" cellpadding="0" id="table21"> <tr> <td width="100%"> <p align="center"><map name="FPMap0"> <area target="5" href="../../blog_071010_post.htm" shape="rect" coords="0, 0, 149, 29"> </map> <img border="0" src="../images/button_comment.gif" usemap="#FPMap4" width="150" height="30"><p align="center"> </td> </tr> </table> </td> </tr> <tr> <td width="100%" bgcolor="#CC9966" height="2"> <img border="0" src="../../../images/blank_2x2.gif" width="2" height="2"></td> </tr> <tr> <td width="0%" valign="top" bgcolor="#FFFFCC"> <table border="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" cellpadding="0" cellspacing="1" id="table22"> <tr> <td align="left" valign="top" bgcolor="#E8FFF0">  </td> </tr> </table> </td> </tr> </table> <table border="0" cellpadding="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" id="table23"> <tr> <td bgcolor="#FFFFCC"> <table border="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" cellpadding="6" bgcolor="#E8FFF0" id="table24"> <tr> <td width="100%" bgcolor="#E8FFF0"> <p align="center" style="margin-top: 18"><map name="FPMap2"> <area target="_top" href="http://www.glynholton.com" shape="rect" coords="0, 0, 192, 76"> </map> <img border="0" src="../images/logo_blog_green.gif" width="193" height="77" usemap="#FPMap2"></p> <p align="center"><span class="verdana10"> <a href="http://www.riskglossary.com/main/disclaimer.htm" target="_self"> Disclaimer</a></span></p> <p align="center">website: <a target="_top" href="http://www.contingencyanalysis.com"> http://www.contingencyanalysis.com</a><br> copyright © Contingency Analysis, 2007<p align="center"> <map name="FPMap3"> <area target="_top" href="http://www.contingencyanalysis.com" shape="rect" coords="0, 0, 240, 88"> </map> <img border="0" src="../images/logo_ca_green.gif" width="241" height="89" usemap="#FPMap3"></td> </tr> </table> </td> </tr> </table> </td> <td>  </td> </tr> </table> </div>  </body>