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Bid-Ask Spreads with Indirect Competition among Specialists

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  • Gehrig, Thomas
  • Jackson, Matthew O.

Abstract

We examine the bid-ask quotes offered by specialists (or dealers) who face indirect competition from other specialists who trade in related assets. In the context of a simple model where investors have mean variance preferences, we characterize the equilibrium bids and asks quoted by K specialists in N assets, where some specialists may control more than one asset. We compare the equilibrium spreads as the number (and factor structure) of the assets each specialist controls is varied. It is shown that for some constellations of initial portfolio holdings and asset covariance it is socially preferable to have competing specialists, while for others it is socially preferable to have their actions coordinated (or to have one specialist control several assets). In a simple factor model, we show how the optimal specialist control structure depends on whether the assets trade as substitutes or complements. In some situations it is beneficial to have specialist power concentrated within industries, in other situations, across industries, and in yet other situations, not to be concentrated at all.

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Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 1648.

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Date of creation: May 1997
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Handle: RePEc:cpr:ceprdp:1648

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Keywords: Bid-Ask Spread; Indirect Competition; Market Structure;

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References

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  1. Grossman, S.J. & Miller, M.H., 1988. "Liquidity And Market Structure," Papers 88, Princeton, Department of Economics - Financial Research Center.
  2. Christie, William G & Schultz, Paul H, 1994. " Why Do NASDAQ Market Makers Avoid Odd-Eighth Quotes?," Journal of Finance, American Finance Association, vol. 49(5), pages 1813-40, December.
  3. Thomas Gehrig, 1993. "Intermediation in Search Markets," Discussion Papers 1058, Northwestern University, Center for Mathematical Studies in Economics and Management Science.
  4. Hagerty, Kathleen, 1991. "Equilibrium Bid-Ask Spreads in Markets with Multiple Assets," Review of Economic Studies, Wiley Blackwell, vol. 58(2), pages 237-57, April.
  5. Hans R. Stoll, . "The Supply of Dealer Services in Securities Markets," Rodney L. White Center for Financial Research Working Papers 02-78, Wharton School Rodney L. White Center for Financial Research.
  6. Dennert, Jurgen, 1993. "Price Competition between Market Makers," Review of Economic Studies, Wiley Blackwell, vol. 60(3), pages 735-51, July.
  7. Matthew O. Jackson & Sandro Brusco, 1997. "The Optimal Design of a Market," Discussion Papers 1186, Northwestern University, Center for Mathematical Studies in Economics and Management Science.
  8. Glosten, Lawrence R. & Milgrom, Paul R., 1985. "Bid, ask and transaction prices in a specialist market with heterogeneously informed traders," Journal of Financial Economics, Elsevier, vol. 14(1), pages 71-100, March.
  9. Ho, Thomas & Stoll, Hans R., 1981. "Optimal dealer pricing under transactions and return uncertainty," Journal of Financial Economics, Elsevier, vol. 9(1), pages 47-73, March.
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  11. Dutta, Prajit K & Madhavan, Ananth, 1997. " Competition and Collusion in Dealer Markets," Journal of Finance, American Finance Association, vol. 52(1), pages 245-76, March.
  12. Madhavan, Ananth & Smidt, Seymour, 1993. " An Analysis of Changes in Specialist Inventories and Quotations," Journal of Finance, American Finance Association, vol. 48(5), pages 1595-1628, December.
  13. Caballe, Jordi & Krishnan, Murugappa, 1994. "Imperfect Competition in a Multi-security Market with Risk Neutrality," Econometrica, Econometric Society, vol. 62(3), pages 695-704, May.
  14. Spence, Michael, 1976. "Product Selection, Fixed Costs, and Monopolistic Competition," Review of Economic Studies, Wiley Blackwell, vol. 43(2), pages 217-35, June.
  15. Ross, Stephen A., 1976. "The arbitrage theory of capital asset pricing," Journal of Economic Theory, Elsevier, vol. 13(3), pages 341-360, December.
  16. Bernhardt, Dan & Hughson, Eric, 1996. "Discrete Pricing and the Design of Dealership Markets," Journal of Economic Theory, Elsevier, vol. 71(1), pages 148-182, October.
  17. Amihud, Yakov & Mendelson, Haim, 1980. "Dealership market : Market-making with inventory," Journal of Financial Economics, Elsevier, vol. 8(1), pages 31-53, March.
  18. Stahl, Konrad, 1982. "Differentiated Products, Consumer Search, and Locational Oligopoly," Journal of Industrial Economics, Wiley Blackwell, vol. 31(1-2), pages 97-113, September.
  19. Hasabrouck, Joel & Sofianos, George, 1993. " The Trades of Market Makers: An Empirical Analysis of NYSE Specialists," Journal of Finance, American Finance Association, vol. 48(5), pages 1565-93, December.
  20. Garman, Mark B., 1976. "Market microstructure," Journal of Financial Economics, Elsevier, vol. 3(3), pages 257-275, June.
  21. Admati, Anat R, 1985. "A Noisy Rational Expectations Equilibrium for Multi-asset Securities Markets," Econometrica, Econometric Society, vol. 53(3), pages 629-57, May.
  22. Asher Wolinsky, 1983. "Retail Trade Concentration Due to Consumers' Imperfect Information," Bell Journal of Economics, The RAND Corporation, vol. 14(1), pages 275-282, Spring.
  23. Christie, William G & Harris, Jeffrey H & Schultz, Paul H, 1994. " Why Did NASDAQ Market Makers Stop Avoiding Odd-Eighth Quotes?," Journal of Finance, American Finance Association, vol. 49(5), pages 1841-60, December.
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Citations

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Cited by:
  1. Corwin, Shane A., 2004. "Specialist performance and new listing allocations on the NYSE: an empirical analysis," Journal of Financial Markets, Elsevier, vol. 7(1), pages 27-51, January.
  2. Coughenour, Jay F. & Saad, Mohsen M., 2004. "Common market makers and commonality in liquidity," Journal of Financial Economics, Elsevier, vol. 73(1), pages 37-69, July.
  3. Sandro Brusco & Matthew O. Jackson, 1997. "The Optimal Design of a Market," Microeconomics 9711003, EconWPA.
  4. Krause, Andreas, 2005. "Optimal stock allocation in specialist markets," Research in Economics, Elsevier, vol. 59(1), pages 23-39, March.
  5. Goodfellow, Christiane & Schiereck, Dirk & Verrier, Tatjana, 2010. "Does screen trading weather the weather? A note on cloudy skies, liquidity, and computerized stock markets," International Review of Financial Analysis, Elsevier, vol. 19(2), pages 77-80, March.
  6. Madhavan, Ananth, 2000. "Market microstructure: A survey," Journal of Financial Markets, Elsevier, vol. 3(3), pages 205-258, August.

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