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The Microeconomics of Market Making

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Author Info
O'Hara, Maureen
Oldfield, George S.
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.

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Publisher Info
Article provided by Cambridge University Press in its journal Journal of Financial and Quantitative Analysis.

Volume (Year): 21 (1986)
Issue (Month): 04 (December)
Pages: 361-376
Download reference. The following formats are available: HTML (with abstract), plain text (with abstract), BibTeX, RIS (EndNote, RefMan, ProCite), ReDIF
Handle: RePEc:cup:jfinqa:v:21:y:1986:i:04:p:361-376_01

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  3. Richard K. Lyons, 1993. "Tests of Microstructural Hypotheses in the Foreign Exchange Market," NBER Working Papers 4471, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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  4. Hollifield, Burton & Miller, Robert & Sandås, Patrik, 2001. "Empirical Analysis of Limit Order Markets," CEPR Discussion Papers 2843, C.E.P.R. Discussion Papers. [Downloadable!] (restricted)
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  5. Toni Gravelle, 2002. "The Microstructure of Multiple-Dealer Equity and Government Securities Markets: How They Differ," Working Papers 02-9, Bank of Canada. [Downloadable!]
  6. John Rust & George Hall, 2001. "Middle Men Versus Market Makers: A Theory of Competitive Exchange," Cowles Foundation Discussion Papers 1299, Cowles Foundation, Yale University. [Downloadable!]
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  7. Robert F. Engle & Joe Lange, 1997. "Measuring, Forecasting and Explaining Time Varying Liquidity in the Stock Market," NBER Working Papers 6129, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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  8. Michael Baye & Ann Gillette & Casper Vries, 1994. "Limit orders, asymmetric information, and the formation of asset prices with a computerized specialist," Journal of Economics, Springer, vol. 59(1), pages 71-96, February. [Downloadable!] (restricted)
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  9. Rafael Romeu, 2004. "A Puzzle of Microstructure Market Maker Models," IMF Working Papers 04/6, International Monetary Fund. [Downloadable!]
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  12. Wai-Ming Fong & Giorgio Valente & Joseph K.W. Fung, 2008. "FX Arbitrage and Market Liquidity: Statistical Significance and Economic Value," Working Papers 082008, Hong Kong Institute for Monetary Research. [Downloadable!]
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  15. Richard K. Lyons, 1995. "Foreign Exchange Volume: Sound and Fury Signifying Nothing?," NBER Working Papers 4984, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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  16. Sugato Chakravarty & Frederick H. deB. Harris & Robert A. Wood, 2002. "Do Bid-Ask Spreads Or Bid and Ask Depths Convey New Information First?," Econometrics 0201003, EconWPA. [Downloadable!]
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  19. Tarun Chordia & Asani Sarkar & Avanidhar Subrahmanyam, 2001. "An Empirical Analysis of Stock and Bond Market Liquidity: Forthcoming in the Review of Financial Studies," University of California at Los Angeles, Anderson Graduate School of Management 1018, Anderson Graduate School of Management, UCLA. [Downloadable!]
  20. Pu Shen & Ross Starr, 2000. "Market Makers' Supply and Pricing of Financial Market Liquidity," University of California at San Diego, Economics Working Paper Series 2000-28, Department of Economics, UC San Diego. [Downloadable!]
  21. Rafael Romeu, 2003. "An Intraday Pricing Model of Foreign Exchange Markets," IMF Working Papers 03/115, International Monetary Fund. [Downloadable!]
  22. C. L. Osler, 2002. "Stop-loss orders and price cascades in currency markets," Staff Reports 150, Federal Reserve Bank of New York. [Downloadable!]
  23. Ron Kaniel & Hong Liu, . "Are Transactions and Market Orders More Important than Limit Orders in the Quote Updating Process?," Rodney L. White Center for Financial Research Working Papers 16-98, Wharton School Rodney L. White Center for Financial Research. [Downloadable!]
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