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Dealing with Dynamic Agency

Author

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  • Benjamin Falkeborg

    (Department of Economics, University of Copenhagen)

Abstract

I study the implications of agency frictions for the pricing policy of institutional market makers. In a setting where a market maker cannot observe the actions of an employed trader, I derive the optimal compensation structure and pricing policy. The theory demonstrates that incentive contracting and the price for immediacy are inherently linked. When the trader’s compensation is optimally deferred according to order flow, market making efficiency is improved and the quoted spreads are minimized. In other words, optimizing trader compensation leads to a liquidity gain.

Suggested Citation

  • Benjamin Falkeborg, 2015. "Dealing with Dynamic Agency," Discussion Papers 15-04, University of Copenhagen. Department of Economics.
    • Handle: RePEc:kud:kuiedp:1504
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    References listed on IDEAS

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    More about this item

    Keywords

    Market Making; Hedging; Dynamic Moral Hazard; Recursive Contracts; Liquidity Provision.;
    All these keywords.

    JEL classification:

    • D81 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Criteria for Decision-Making under Risk and Uncertainty
    • D86 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Economics of Contract Law
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • J33 - Labor and Demographic Economics - - Wages, Compensation, and Labor Costs - - - Compensation Packages; Payment Methods

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