Market Making With Fads, Informed, and Uninformed Traders

ABSTRACT We characterize the solution to a continuous‐time optimal liquidity provision problem in a market populated by informed and uninformed traders. In our model, the asset price exhibits fads —these are short‐term deviations from the fundamental value of the asset. Conditional on the value of the fad, we model how informed traders and uninformed traders arrive in the market. The market maker is aware of the existence of the two groups of traders but only observes the anonymous order arrivals. We study both, the complete and the partial information versions of the control problem faced by the market maker. In such frameworks, we characterize the value of information, and we find the price of liquidity as a function of the proportion of informed traders in the market. We discuss how to calibrate model parameters from market data and we quantify the outperformance over strategies that ignore these unobservable short‐term deviations. Lastly, for the partial information setup, we explore how to go beyond the Kalman–Bucy filter to extract information about the fad from the market arrivals.