Market makers' supply and pricing of financial market liquidity
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.
File(s): File format is application/pdf http://www.kansascityfed.org/Publicat/Reswkpap/PDF/rwp00-03.pdf
Provider: Federal Reserve Bank of Kansas City
Part of Series: Research Working Paper
Publication Date: 2000
Number: RWP 00-03