Market Makers' Supply and Pricing of Financial Market Liquidity

UCSD Economics Working Paper No. 2000-28

17 Pages Posted: 17 Apr 2001

See all articles by Pu Shen

Pu Shen

Federal Reserve Bank of Kansas City - Economic Research Department

Ross M. Starr

University of California at San Diego

Date Written: November 2000

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: Liquidity, market maker, bid-ask spread

JEL Classification: G12

Suggested Citation

Shen, Pu and Starr, Ross, Market Makers' Supply and Pricing of Financial Market Liquidity (November 2000). UCSD Economics Working Paper No. 2000-28, Available at SSRN: https://ssrn.com/abstract=256105 or http://dx.doi.org/10.2139/ssrn.256105

Pu Shen (Contact Author)

Federal Reserve Bank of Kansas City - Economic Research Department ( email )

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Ross Starr

University of California at San Diego ( email )

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