A hot-potato game under transient price impact

Alexander Schied
Universität Mannheim
Department of Mathematics

We consider a Nash equilibrium between two high-frequency traders in a simple market impact model with transient price impact and additional quadratic transaction costs. Extending a result by Schöneborn (2008), we prove existence and uniqueness of the Nash equilibrium and show that for small transaction costs the high-frequency traders engage in a "hot-potato game", in which the same asset position is sold back and forth. We then identify a critical value for the size of the transaction costs above which all oscillations disappear and strategies become buy-only or sell-only. We also provide precise asymptotics for the strategies and theior expected costs in the high-frequency limit. As a corollary, we prove that for both traders the expected costs can be lower with transaction costs than without. Moreover, the costs can increase with the trading frequency when there are no transaction costs, but decrease with the trading frequency when transaction costs are sufficiently high. We argue that these effects occur due to the need of protection against predatory trading in the regime of low transaction costs. Finally, we discuss whether the limiting strategies can be regarded as equilibrium strategies for a continuous-time differential game.This is joint work with Elias Strehle and Tao Zhang.

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