Liquidity Supply by a Risk‐Averse Market Maker

Abstract

Market makers bear enormous uncertainty of the values of their portfolios and their attitude towards risk should not be completely ignored. In this article, we analyse a quote‐driven market of a risky financial asset, where a risk‐averse market maker supplies liquidity to traders. We characterise the equilibrium of the market for trading based on liquidity demand/diverse opinions on the value of the risky asset or based on information asymmetry. We find that risk aversion of the market maker is likely to increase the non‐participation range of traders and the bid‐ask spread.

JEL Classification: D82, G12