Strategic Market Making and Risk Sharing

31 Pages Posted: 15 Mar 2006

See all articles by Laurent Germain

Laurent Germain

Toulouse University, Toulouse Business School

Fabrice Rousseau

National University of Ireland, Maynooth (NUI Maynooth) - Department of Economics, Finance and Accounting

Date Written: September 2005

Abstract

We analyze the result of allowing risk averse traders to split their orders among markets when market makers are assumed to be risk averse.

We prove that linear symmetric equilibria exist in that setting. We find that market makers' aggregate expected utility of profit may increase with the number of market markers despite the fact that the aggregate liquidity always increases with it. This implies that the cost of trading for the traders may increase with the number of market makers. The larger the market makers' risk aversion, the bigger that cost is. We also find that when the number of market makers tends to infinity, their aggregate expected utility of profit tends to zero. We offer a potential answer to the ongoing debate concerning the dealers' competitiveness. Indeed, risk aversion reduces competition between market makers as it acts as a commitment for market makers to set higher prices. This commitment is higher the higher the risk aversion.

Keywords: Risk aversion, splitting orders, strategic market making

JEL Classification: G14, D82

Suggested Citation

Germain, Laurent and Rousseau, Fabrice, Strategic Market Making and Risk Sharing (September 2005). Available at SSRN: https://ssrn.com/abstract=819745 or http://dx.doi.org/10.2139/ssrn.819745

Laurent Germain (Contact Author)

Toulouse University, Toulouse Business School ( email )

20, bd Lascrosses
Toulouse, 31000
France

Fabrice Rousseau

National University of Ireland, Maynooth (NUI Maynooth) - Department of Economics, Finance and Accounting ( email )

County Kildare
Ireland
+353 (0) 1 7084568 (Phone)

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