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Market making with asymmetric information and inventory risk

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  • Liu, Hong
  • Wang, Yajun

Abstract

Market makers in some financial markets often make offsetting trades and have significant market power. We develop a market making model that captures these market features as well as other important characteristics such as information asymmetry and inventory risk. In contrast to the existing literature, a market maker in our model can optimally shift some trades with some investors to other investors by adjusting bid or ask. As a result, we find that consistent with empirical evidence, expected bid–ask spreads may decrease with information asymmetry and bid–ask spreads can be positively correlated with trading volume.

Suggested Citation

  • Liu, Hong & Wang, Yajun, 2016. "Market making with asymmetric information and inventory risk," Journal of Economic Theory, Elsevier, vol. 163(C), pages 73-109.
  • Handle: RePEc:eee:jetheo:v:163:y:2016:i:c:p:73-109 DOI: 10.1016/j.jet.2016.01.005
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    References listed on IDEAS

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    Cited by:

    1. David A. Cimon & Corey Garriott, 2017. "Banking Regulation and Market Making," Staff Working Papers 17-7, Bank of Canada.
    2. Michail Anthropelos & Constantinos Kardaras & Georgios Vichos, 2017. "Effective risk aversion in thin risk-sharing markets," Papers 1707.05096, arXiv.org.
    3. Alhaj-Yaseen, Yaseen S. & Rao, Xi & Jin, Yinghua, 2017. "Market liberalization and the extent of informed trading: Evidence from China’s equity markets," Journal of Multinational Financial Management, Elsevier, vol. 39(C), pages 78-99.

    More about this item

    Keywords

    Market making; Illiquidity; Bid–ask spread; Asymmetric information; Imperfect competition;

    JEL classification:

    • D42 - Microeconomics - - Market Structure, Pricing, and Design - - - Monopoly
    • D53 - Microeconomics - - General Equilibrium and Disequilibrium - - - Financial Markets
    • D82 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Asymmetric and Private Information; Mechanism Design
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G18 - Financial Economics - - General Financial Markets - - - Government Policy and Regulation

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