Market makers' optimal price-setting policy for exchange-traded certificates

This paper presents the first theoretical model of the profit maximizing price-setting policy for the issuers of exchange-traded retail certificates. Unlike previous theoretical microstructure models, the market considered is unique in that the market makers do not face significant inventory costs or risk from informed traders. The model derives the time structure of the optimal markups over a certificate's fair theoretical value and its relationship with optimal spreads, unhedgeable risk faced by the issuer and investors' buying and selling decisions. It shows that (i) the optimal markups decrease inter-temporally, (ii) issuers adjust the markups according to investors' demand, (iii) unhedgeable risk results in higher markups and influences their time structure, (iv) the markups and the spread are negatively related. Using data from the German market for leverage certificates, we find strong empirical support for the model-derived hypotheses, except for (iv). We find spreads exhibit little variation and this suggests that markups and spreads are not substitute profit sources for issuers in this market.