Market Makers and Risk Aversion: A Hamiltonian Approach to the Excess Volatility Puzzle

Abstract

In this article we model chaotic dynamics in financial markets by treating the market price, and market makers' inventory, as anharmonic oscillators with a nonlinear coupling. The market makers' risk appetite being the key parameter that determines the degree of chaos in the system. The article demonstrates that whilst external shocks and random noise are important in the treatment of financial time-series, they are not necessary in order to generate unpredictable price changes.