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The Microeconomics of Market Making

Published online by Cambridge University Press:  06 April 2009

Maureen O'Hara  and
George S. Oldfield
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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.

Type
Research Article
Information
Journal of Financial and Quantitative Analysis , Volume 21 , Issue 4 , December 1986 , pp. 361 - 376
Copyright
Copyright © School of Business Administration, University of Washington 1986

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References

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