•   •   •   •

Download the Paper (97 K, PDF file) - November 2, 2000 Tell a colleague about it. Printing Tips: Select 'print as image' in the Acrobat print dialog if you have trouble printing.

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.

SUGGESTED CITATION:
Pu Shen and Ross M. Starr, "Market Makers' Supply and Pricing of Financial Market Liquidity" (November 2, 2000). Department of Economics, UCSD. Paper 2000-28.
http://repositories.cdlib.org/ucsdecon/2000-28