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Market makers' supply and pricing of financial market liquidity

Author

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  • Pu Shen
  • Ross M. Starr

Abstract

This study models the bid-ask spread in financial markets as a function of asset price variability and order flow. The market-maker is characterized as passively accepting orders to buy and to sell a security at the market's prevailing price (plus or minus half the bid-ask spread). The bid-ask spread adjusts to cover market-makers' average costs. The bid-ask spread then varies positively with: the security's price volatility, the volatility of order flow, and the absolute value of the market-maker's net inventory position. Each of these variables increases average cost and hence is priced in the bid-ask spread. Thus market liquidity (varying inversely with the bid-ask spread) declines with increasing price and volume volatility and with increasing size of market-maker net inventory positions. The model hence provides a particularly simple explanation for declining market liquidity during periods of large price movements and trading imbalances that increase the size of market-makers' net inventory.

Suggested Citation

  • Pu Shen & Ross M. Starr, 2000. "Market makers' supply and pricing of financial market liquidity," Research Working Paper RWP 00-03, Federal Reserve Bank of Kansas City.
    • Handle: RePEc:fip:fedkrw:rwp00-03
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    File URL: https://www.kansascityfed.org/documents/5425/pdf-RWP00-03.pdf
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    References listed on IDEAS

    as
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    7. Amihud, Yakov & Mendelson, Haim, 1980. "Dealership market : Market-making with inventory," Journal of Financial Economics, Elsevier, vol. 8(1), pages 31-53, March.
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    Cited by:

    1. Giuseppe Galloppo & Victoria Paimanova, 2018. "Efficiency and transparency effects on Eastern European financial markets," International Economics and Economic Policy, Springer, vol. 15(1), pages 185-213, January.

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    Keywords

    Financial markets; Liquidity (Economics);

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