Quiz: Liquidity Provision and Market Making
Test your understanding of the concepts covered in Chapter 29. Each question has one best answer. Answers are hidden below each question.
Question 1
What is the primary role of a market maker in a prediction market?
- (A) To profit from predicting outcomes correctly
- (B) To provide continuous buy and sell quotes, ensuring liquidity
- (C) To regulate the market and prevent fraud
- (D) To determine the official resolution of events
Answer
**(B)** A market maker provides continuous two-sided quotes (bids and asks), ensuring that other participants can trade immediately rather than waiting for a natural counterparty. While market makers may profit from their activity, their primary function is liquidity provision.Question 2
The bid-ask spread compensates market makers for which of the following costs?
- (A) Adverse selection, inventory risk, and operational costs
- (B) Trading fees, platform subscriptions, and data costs
- (C) Capital gains taxes, opportunity costs, and insurance premiums
- (D) Marketing expenses, legal fees, and compliance costs
Answer
**(A)** The three fundamental cost components of the bid-ask spread are adverse selection (trading against informed participants), inventory carrying cost (directional risk from net positions), and operational costs (technology, capital, and time).Question 3
In the Glosten-Milgrom model, what happens to the bid-ask spread as the fraction of informed traders ($\alpha$) increases?
- (A) The spread narrows
- (B) The spread widens
- (C) The spread remains unchanged
- (D) The spread first narrows then widens
Answer
**(B)** As $\alpha$ increases, the market maker faces greater adverse selection risk. To compensate, the market maker must widen the spread. This is a fundamental result of the Glosten-Milgrom model.Question 4
In a prediction market where $\mu = 0.50$ and $\alpha = 0.30$, the Glosten-Milgrom model predicts that after a sequence of four consecutive buy trades, the market maker's estimate of $\mu$ will:
- (A) Remain at 0.50
- (B) Increase above 0.50
- (C) Decrease below 0.50
- (D) Oscillate around 0.50
Answer
**(B)** Each buy trade is more likely from an informed trader who knows the event will occur. Through Bayesian updating, consecutive buy trades cause the market maker to revise $\mu$ upward, reflecting increased belief that the event is likely.Question 5
A realized spread that is consistently negative indicates:
- (A) The market maker is charging too much
- (B) The market maker is profitable
- (C) The market maker is losing money to informed traders
- (D) The market is efficiently priced
Answer
**(C)** A negative realized spread means that, on average, the price moves against the market maker after each trade by more than the half-spread earned. This is the hallmark of adverse selection: informed traders extract value from the market maker.Question 6
In the Avellaneda-Stoikov framework, when a market maker has a large long inventory ($q \gg 0$), the optimal strategy is to:
- (A) Widen both bid and ask equally
- (B) Shift both bid and ask downward (making selling more likely)
- (C) Shift both bid and ask upward (making buying more likely)
- (D) Withdraw from the market entirely
Answer
**(B)** The Avellaneda-Stoikov framework prescribes shifting both quotes in the direction that reduces inventory. When long ($q > 0$), the adjustment term $-\gamma q \sigma^2 (T-t)$ is negative, shifting both bid and ask downward. This makes the market maker's sell price more competitive, encouraging fills that reduce the long position.Question 7
What is the maximum possible loss for an LMSR with liquidity parameter $b = 200$ in a binary market?
- (A) $\$200$
- (B) $\$138.63$
- (C) $\$100$
- (D) $\$400$
Answer
**(B)** The maximum loss of an LMSR with $n$ outcomes is $b \cdot \ln(n)$. For a binary market ($n = 2$): $200 \cdot \ln(2) \approx 200 \cdot 0.6931 \approx \$138.63$.Question 8
Which of the following is NOT a common method of subsidizing market making in prediction markets?
- (A) Direct payments for maintaining quotes
- (B) Loss protection reimbursement
- (C) Allowing market makers to see other traders' identities
- (D) Fee rebates for liquidity providers
Answer
**(C)** Common subsidy mechanisms include direct payments, loss protection, AMMs funded by the platform, fee rebates, and liquidity mining. Revealing trader identities is not a subsidy mechanism—it is a privacy concern and not standard practice.Question 9
A market maker uses a linear skew with $\kappa = 0.0002$ and currently holds an inventory of $q = +300$ contracts. The fair value is $0.50$ and the base spread is $0.04$. What are the quoted bid and ask?
- (A) Bid = 0.42, Ask = 0.58
- (B) Bid = 0.42, Ask = 0.46
- (C) Bid = 0.48, Ask = 0.52
- (D) Bid = 0.42, Ask = 0.46
Answer
**(A)** Wait—let me recalculate. The skew is $\Delta = -\kappa \cdot q = -0.0002 \times 300 = -0.06$. The bid is $0.50 - 0.02 + (-0.06) = 0.42$. The ask is $0.50 + 0.02 + (-0.06) = 0.46$. The correct answer is **(D)**: Bid = 0.42, Ask = 0.46. Both quotes shift down by 0.06 due to the long inventory, incentivizing sells and discouraging buys.Question 10
VPIN (Volume-Synchronized Probability of Informed Trading) measures:
- (A) The fraction of total volume attributable to informed traders
- (B) The price impact of each trade
- (C) The market maker's realized P&L per unit volume
- (D) The correlation between order flow and price changes
Answer
**(A)** VPIN estimates the fraction of trading volume that is information-driven by measuring the absolute order imbalance within volume-synchronized buckets. A high VPIN (close to 1) indicates that most trading is directional (likely informed), while a low VPIN (close to 0) indicates balanced two-way flow (likely uninformed).Question 11
In the context of AMM-based prediction markets, "impermanent loss" at resolution is:
- (A) Zero, because the market resolves to a known value
- (B) Guaranteed to be maximum, because one outcome goes to 0
- (C) Dependent on the path of prices during the market's lifetime
- (D) Always offset by trading fees
Answer
**(B)** At resolution, one outcome goes to $1$ and the other goes to $0$, which means the LP has been fully arbitraged into holding only the losing outcome token. This guarantees maximum impermanent loss, making LP economics in prediction markets fundamentally different from perpetual pools.Question 12
Kyle's lambda ($\lambda$) measures:
- (A) The probability that a trader is informed
- (B) The price impact per unit of signed order flow
- (C) The market maker's risk aversion
- (D) The optimal bid-ask spread
Answer
**(B)** Kyle's lambda is estimated from the regression $\Delta m_t = \lambda \cdot \text{OFI}_t + \epsilon_t$, where $\Delta m_t$ is the mid-price change and $\text{OFI}_t$ is the signed order flow imbalance. A higher $\lambda$ means each unit of order flow has a larger price impact, indicating more informed trading.Question 13
A market maker should widen their spread when:
- (A) Volume is high and adverse selection is low
- (B) Volume is low and adverse selection is low
- (C) Adverse selection metrics spike and inventory is large
- (D) The market is approaching resolution and the price is near 0.50
Answer
**(C)** Market makers should widen spreads when adverse selection is high (to compensate for informed flow) and when inventory is large (to reduce the risk of further accumulation). Situations (A) and (B) would typically warrant normal or narrower spreads. Situation (D) has high uncertainty but is not directly about spread widening—though approaching resolution with extreme adverse selection would warrant widening.Question 14
In multi-market market making, correlation between markets matters because:
- (A) Correlated markets are always more profitable
- (B) Correlation affects portfolio-level risk, and inventory in correlated markets may compound directional exposure
- (C) Uncorrelated markets cannot be market-made simultaneously
- (D) Correlation determines the LMSR liquidity parameter
Answer
**(B)** When markets are correlated, holding long positions in both means the portfolio risk is higher than the sum of individual risks would suggest. Market makers must account for these correlations in their risk management, adjusting spreads and position limits for correlated markets.Question 15
Which quote strategy shifts both bid and ask prices in the same direction based on inventory?
- (A) Symmetric quoting
- (B) Layered quoting
- (C) Skewed quoting (inventory-based)
- (D) Signal-based quoting
Answer
**(C)** Skewed quoting shifts both the bid and ask by the same amount ($\Delta_{\text{skew}} = -\kappa q$), moving the center of the quotes away from the current inventory direction. This makes the market maker more competitive on the side that reduces inventory.Question 16
A prediction market binary contract is priced at $0.90$. Compared to one priced at $0.50$, the market maker faces:
- (A) Less adverse selection because the outcome is nearly certain
- (B) More adverse selection because any trade against the market maker at this price is likely informed
- (C) The same adverse selection regardless of price level
- (D) Less inventory risk because the contract is more valuable
Answer
**(B)** When a contract is priced near $0.90$, a sell trade is very likely informed—only someone who knows the event will NOT occur would sell at such a high price. While the Glosten-Milgrom spread narrows near extreme prices, the asymmetry of information is more acute. However, the model shows the spread narrows because the adverse selection cost per trade decreases—the key nuance is that the *conditional* adverse selection on a sell trade is very high, even though the overall spread may narrow.Question 17
Concentrated liquidity in prediction markets is particularly useful because:
- (A) It eliminates impermanent loss
- (B) It allows LPs to focus capital in the most likely price range, improving fee efficiency
- (C) It guarantees profits for liquidity providers
- (D) It prevents informed traders from extracting value
Answer
**(B)** Concentrated liquidity allows LPs to deploy their capital only within a specific price range, earning higher fees per dollar deployed compared to full-range liquidity. However, it does not eliminate impermanent loss (which may actually be more severe for concentrated positions) and does not guarantee profits.Question 18
A market maker's circuit breaker should be triggered when:
- (A) Any single trade results in a loss
- (B) Cumulative daily losses exceed a predetermined threshold
- (C) The market becomes more volatile
- (D) A competitor enters the market
Answer
**(B)** Circuit breakers are designed to prevent catastrophic losses by halting all quoting activity when cumulative losses exceed a threshold. Single-trade losses are normal, volatility can be addressed by spread widening, and competitor entry does not warrant stopping. Only accumulated losses that threaten the market maker's capital should trigger a full shutdown.Question 19
In the Glosten-Milgrom model, the ask price can be interpreted as:
- (A) The market maker's best guess of the probability
- (B) The conditional expectation of the contract value given that a buy order arrives
- (C) The price that maximizes the market maker's profit
- (D) The midpoint between the true value and 1.0
Answer
**(B)** The ask price in the Glosten-Milgrom model is set to the conditional expectation $\mathbb{E}[\text{value} \mid \text{buy order}]$. This is the zero-profit condition: the market maker prices the ask such that they break even on average when a buy order arrives (accounting for both informed and uninformed buyers).Question 20
The realized spread formula is $s_{\text{realized}} = 2 \cdot \text{sign}(q) \cdot (p_{\text{trade}} - m_{t+\Delta t})$. If a buy trade occurs at $p = 0.52$ and the mid-price 1 minute later is $0.54$, the realized spread is:
- (A) +0.04
- (B) -0.04
- (C) +0.02
- (D) -0.02
Answer
**(B)** For a buy trade, $\text{sign}(q) = +1$. The realized spread is $2 \times 1 \times (0.52 - 0.54) = 2 \times (-0.02) = -0.04$. The negative realized spread indicates that the mid-price moved against the market maker (upward after a buy fill), suggesting the trade was informed.Question 21
A platform uses an LMSR with $b = 100$ for a 3-outcome market. The maximum subsidy is:
- (A) $\$69.31$
- (B) $\$100.00$
- (C) $\$109.86$
- (D) $\$200.00$
Answer
**(C)** Maximum loss $= b \cdot \ln(n) = 100 \cdot \ln(3) \approx 100 \times 1.0986 = \$109.86$.Question 22
What is the key difference between prediction market market making and traditional equity market making regarding hedging?
- (A) Prediction market contracts can always be hedged
- (B) Prediction market positions on idiosyncratic events typically cannot be hedged with other instruments
- (C) Equity market makers never hedge their positions
- (D) Both use identical hedging strategies
Answer
**(B)** Prediction market events are often idiosyncratic (e.g., "Will candidate X win?"), meaning there are no correlated assets that can be used for hedging. Equity market makers can hedge with index futures, options, and correlated stocks. This makes inventory management in prediction markets especially critical.Question 23
When asymmetric spread quoting is used with $\eta > 0$ and the market maker is long ($q > 0$):
- (A) Both bid and ask widen equally
- (B) The bid widens and the ask narrows
- (C) The bid narrows and the ask widens
- (D) Both bid and ask narrow
Answer
**(B)** With asymmetric spread quoting, when $q > 0$: the bid half-spread is multiplied by $(1 + \eta q)$ (wider, less aggressive buying) and the ask half-spread is multiplied by $(1 - \eta q)$ (narrower, more aggressive selling). This encourages fills on the sell side to reduce the long inventory.Question 24
A risk-parity approach to multi-market capital allocation assigns more capital to:
- (A) Markets with the highest expected returns
- (B) Markets with the lowest risk (volatility)
- (C) Markets with the highest volume
- (D) Markets with the most correlated outcomes
Answer
**(B)** Risk parity allocates capital inversely proportional to risk. Markets with lower volatility receive more capital because the same dollar amount buys more "risk units." This ensures each market contributes equally to total portfolio risk, maximizing diversification.Question 25
A market maker should consider stopping market making when:
- (A) The spread is profitable and volume is high
- (B) Daily loss limits are hit, adverse selection spikes, or the market approaches resolution with large binary payoff risk
- (C) Competitor market makers have wider spreads
- (D) The market has just opened and there is no trade history