Market making with asymmetric information and inventory risk

Hong Liu and Yajun Wang

Journal of Economic Theory, 2016, vol. 163, issue C, 73-109

Abstract: Market makers in some financial markets often make offsetting trades and have significant market power. We develop a market making model that captures these market features as well as other important characteristics such as information asymmetry and inventory risk. In contrast to the existing literature, a market maker in our model can optimally shift some trades with some investors to other investors by adjusting bid or ask. As a result, we find that consistent with empirical evidence, expected bid–ask spreads may decrease with information asymmetry and bid–ask spreads can be positively correlated with trading volume.

Keywords: Market making; Illiquidity; Bid–ask spread; Asymmetric information; Imperfect competition (search for similar items in EconPapers)
JEL-codes: D42 D53 D82 G12 G18 (search for similar items in EconPapers)
Date: 2016
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (19)

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Persistent link: https://EconPapers.repec.org/RePEc:eee:jetheo:v:163:y:2016:i:c:p:73-109

DOI: 10.1016/j.jet.2016.01.005

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