A Model of Market Making with Heterogeneous Speculators

I introduce an optimizing monopolistic market maker in an otherwise standard setting a la Brock and Hommes (1998) (BH98). The market maker manages her inventory of a zero yielding asset, such as foreign currency, and can earn profits from trading, taking advantage of her knowledge of speculators' demand. The resulting dynamic behavior is qualitatively identical to the one described in BH98, showing that the results of the latter are independent from the institutional framework of the market. At the same time I show that the market maker has conflicting effects. She acts as a stabilizer when she allows for market imbalances, while she acts as a destabilizer when she manages aggressively her inventories and when she trades actively, both if she acts as fundamentalist or if she is a strong extrapolator. Indeed the more stable institutional framework is one in which market makers are inventory neutral and don't trade actively but, even in this case, the typical complex behavior of BH98 occurs.