Optimal bid-ask price strategies

Blyth Archibald, Jerome B Baesel and Dawson E Brewer

Omega, 1982, vol. 10, issue 3, 309-319

Abstract: Economic analysis has begun to focus on the implications of transaction costs to trading in capital assets. Specifically, the economics of market making and the price of liquidity has received considerable attention. This paper formulates the market maker's bid-ask price decision as a semi-Markov decision process with the reward being a function of expected return and risk. Risk is intimately related to dealer inventory and hence the solution of the analysis specifies bid-ask price strategies which are inventory dependent. Numerical examples indicate the market maker's optimal bid-ask prices will tilt around the 'assets' equilibrium price to control inventory as well as influence expected profit.

Date: 1982
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