Make a market questions with a twist
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Scenario 1)
Thats when you get run over in the real world..Pricing purely depends on your confidence interval & your inventory. If you think the interviewer knows more about the price of the chair, your best bet is to widen out your quotes and jack up the prices, and probably hack out most of the trades until you find a two-way flow. If you think you are more confident about the price, then you retreat less and slowly try to sell more.
Not sure what scenario 2 means..
Thanks Eignite,
If his theoretical value is lets say lower than 20, then he will probably sell 20 to scalp his buys at 15 and 17.5 to lock in his profit. then you know his theoretical value is between 15~20 and tighten your market.
Your intuition is correct. This is good trading since you are selling at progressively higher prices. Let him lift you all day... just keep moving the offer higher and feel free to widen out
If there are more chairs 20/50/100, widen the market out (take more bid/offer) since the larger the position is, the harder it will be to hedge due to lower liquidity in that size.
2a. If you want to be good, you can show him 1 price for the first 20. A second wider level for the 50, and the third level for 100 up
Thanks
You can adjust your market to reflect whether you want to buy or sell.
I agree with your logic. The chairs example is sort of theoretical, but let's keep get back to reality with a real world example: In the market, larger positions have more risk inherently, so a wider market should be shown to compensate the dealer for the additional risk. Also, if the dealer decides to offset the position (hedge) he may get poor levels on his hedges if the trade is big enough (he may drive the price up if he is buying or down if he is selling). If the trade is small, the trade can easily be hedged. Sometimes, if the trade is small enough, dealers will do trades for free, as there is little risk and it keeps customers happy so when there is a bigger trade... they can make more P/L
Thanks
Typed out a long azz reply but then got some weird error...
Short version:
Assuming no news comes out and the guy buys 1 chair from you, there isn't a reason to deviate from your initial valuation (12.5) but you should skew your quote. 10-15 should now become 11-16 or 12-18 etc. There is no reason for you to buy the chair at more than you think it's worth so a 13-17 quote doesn't make sense. Mid is the same but you are a better buyer now so your quote reflects that. If the guy buys 100 chairs from you when the market size is 2x2 then that's different.
There may be some market moving events inbetween trading periods. It doesn't make sense with just 2 people otherwise as that's just a zero sum game. You change your price accordingly as the news come out.
Thanks
1 + 2 , Yes you're right. I suppose it depends on what type of market making exercise it is and how confident you are of the right valuation at each stage.
E.g. 1: Make me a market on the total number of pips (dots) on 5 randomly rolled dice. Before any dice is rolled, the expected value is 17.5. You should be confident making a 15-20 market (or even tighter). Say you get lifted at 20. Your mid here is still 17.5 but you would rather make a 17-24 market. Even if there are only 2 people in the market, you would not buy at more than 17.5 here. First dice comes. It's a 6. Now your mid market is really 20. You reprice accordingly.
This was more the situation I was thinking about but come to think of it, I did not make my assumptions clear. This game assumes that the interviewer is simply a price taker. Everyone knows the expected value of a dice (like people know where mid market is IRL) but they are paying you a premium to take on the other side of the trade. You are the house and they are the punter.
E.g. 2: Make me a market on the number of tables (I'm creative like that!) on this floor. Now in this case you could never really know the right answer. The guy knows the answer (I mean at least he already thought of a number that is supposed to be the right answer). I guess this is more the situation you were thinking about.
In this scenario, you are sure to lose money (unless you guess bang on but what's the fun in that?). The aim of the game is therefore to get to the right price with the smallest loss possible. An obvious strategy would be as you describe i.e. selling at progressively higher prices. To minimise the loss, minimise your initial size and make super wide market. The key here is to keep track of your inventories and they average price you buys/sell it for. This helps you make the right price.
Now you see the right strategy is different in each scenario and even in the same scenario, I would argue that there is more than 1 right strategy. So your first step really should be gather as much information about the rules of the game and the information the other guy has. He may laugh and not offer any but if you don't ask, you don't get.
3, Say, mid is X. The price out there is X-2, X+2. However, you're already short some so you are willing to buy it back at X-1 or even at mid. You quote a X-1, X+2 market even though mid is X. This means you're a better buyer.
long_vega above already explained the real life dynamic of pricing/ hedging trades depending on size so not sure what else i could add.
I would suggest that you should be the one introducing different sizes into the game, as the folks above suggested. Particularly, in scenario 2 when you think the guy has more info than you do. You KNOW that you are paying up for the info. You want to pay £1 or even 1p if you can. Say your initial valuation is wrong, you do not want to be stuffed with 100 chairs at the wrong price. You can always say, i'm only good for X amount at Y price and, as suggested above, widen your price to accommodate the size. Once you know where the right price is, you can increase your size then. Hope that makes sense.
Let's throw in some numbers for these chairs again. Your initial valuation = 12.5 but the guy knows it's 20 instead. You quote 10-15. If the guy says how about 5 chairs, well, you know something is up but you don't know which way as he didn't reveal his direction on purpose. You widen out to 7.5-17.5. Or you can guess that you've likely undervalued the chair as it should cost at least 1p (not that far from 10). Your quote can be 8.5-18.5 or 5-20 or 10-40 instead etc etc
Thanks
If you make a 8-17 market and got hit and you freaked tf out then well you priced it wrong. Think about that BEFORE you make a price. It's not just about guessing where the right price is but also the price you are comfortable taking the risk on.
If you truly know it's 12.5 then yes i wouldn't move my bid to above that. If you sold a chair at 15, moved your market to 14-19 then the guy sells you 100 chairs at 14, what do you do? Again, this is why size is also important.
Most importantly, there are more than 1 strategy in this exercise but many many ways to f it up. Others may not agree with my strategy above but I know i'm able to justify it in an interview situation.
My favorite is far more simplisitic -
Why has capitalism succeded, and will it continue to?
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