Market makers' supply and pricing of financial market liquidity

Pu Shen and Ross M. Starr

No RWP 00-03, Research Working Paper from Federal Reserve Bank of Kansas City

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.

Keywords: Financial markets; Liquidity (Economics) (search for similar items in EconPapers)
Date: 2000
New Economics Papers: this item is included in nep-fmk
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Citations: View citations in EconPapers (1)

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