Dynamic Market Making and Asset Pricing​

We develop a dynamic model of market making with asymmetric information and imperfectly competitive market makers. Our model captures key features of market making in many financial markets: in the presence of information asymmetry and limited risk-bearing capacity, market makers optimally make offsetting trades in bid and ask markets by adjusting bid and ask prices/depths to avoid the risk of holding inventories. We solve for equilibrium endogenous bid and ask prices and trading volume analytically. Consistent with empirical findings, we find that when market makers have significant market power, other traders optimally smooth out their trading even though they are not strategic. The market power of market makers dampens and spreads out trading spikes due to either new information arrivals or liquidity shocks. Consequently, trading persists even after arrivals of information and liquidity shocks. In addition, traders tend to trade quickly on their private information while postponing their hedging trades until later periods. As a result, both trading volume and bid-ask spread may exhibit U-shaped patterns. Higher trading frequency mitigates market makers’ market power, and thus decreases bid and ask spreads and increases total trading volume. Therefore, while more trading rounds make other traders better off, they may make market makers worse off.

Associate Professor Yajun Wang

Yajun Wang is an associate professor of finance at Baruch College’s Zicklin School of Business. Before joining the Zicklin School, Dr. Wang was on the faculty at the Robert Smith School of Business of University of Maryland at College Park. Dr. Wang’s research focuses on theoretical market microstructure and its links with asset pricing. Her work in this area contributes to the understanding of (i) how market makers optimally make offsetting trades in the presence of asymmetric information and inventory risk and its impact on asset pricing; (ii) the optimal speed of trading by large asset managers who seek out risks to exploit private information about individual stocks and how the interactions among asset managers affect market stability and liquidity; and (iii) the effects of market frictions such as margin requirements, short-sale constraints, information asymmetry, transaction costs, and imperfect competition on asset prices, market volatility, market illiquidity, and social welfare. She received her PhD in Finance from Washington University in St. Louis.

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