Dealing with Dynamic Agency

Benjamin Falkeborg
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Benjamin Falkeborg: Department of Economics, University of Copenhagen

No 15-04, Discussion Papers from University of Copenhagen. Department of Economics

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.

Keywords: Market Making; Hedging; Dynamic Moral Hazard; Recursive Contracts; Liquidity Provision. (search for similar items in EconPapers)
JEL-codes: D81 D86 G12 J33 (search for similar items in EconPapers)
Pages: 41 pages
Date: 2015-02-27
New Economics Papers: this item is included in nep-cta and nep-hrm
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