Article1986

The Microeconomics of Market Making

348 citations0/0 files storedJournal of Financial and Quantitative Analysis

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Financial Markets and Investment Strategies Stochastic processes and financial applications Economic theories and models

Abstract

This paper examines the influence of risk aversion on the pricing policies of a market maker for securities. It is shown that a market maker's bid-ask spread can be decomposed into a portion for the known limit orders, a risk-neutral adjustment for expected market orders, and a risk adjustment for market order and inventory value uncertainty. It is demonstrated that a risk-averse market maker may set a smaller spread than a risk-neutral specialist. Finally, this paper demonstrates the pervasive role of inventory in affecting both the placement and size of the spread.

Citations in this library

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References

1968The Cost of Transacting 1981Optimal dealer pricing under transactions and return uncertainty 1980Dealership market 1981Transaction Costs, Order Placement Strategy, and Existence of the Bid-Ask Spread

Cited by

1995Consolidation, Fragmentation, and the Disclosure of Trading Information 1991A Bayesian model of intraday specialist pricing 1993The seasonal behavior of the liquidity premium in asset pricing 2004Common market makers and commonality in liquidity 2007Leaning Against the Wind 1998Is There Private Information in the FX Market? The Tokyo Experiment 2007Stock and Bond Market Liquidity: A Long-Run Empirical Analysis 1999Limit orders and the bid–ask spread

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