Market Making with Discrete Prices
- 1 January 1998
- journal article
- research article
- Published by Oxford University Press (OUP) in The Review of Financial Studies
- Vol. 11 (1) , 81-109
- https://doi.org/10.1093/rfs/11.1.81
Abstract
Exchange-mandated discrete pricing restrictions create a wedge between the underlying equilibrium price and the observed price. This wedge permits a competitive market maker to realize economic profits that could help recoup fixed costs. The optimal tick size that maximizes the expected profits of the market maker can equal to $1/8 for reasonable parameter values. The optimal tick size is decreasing in the degree of adverse selection. Discreteness per se can cause time-varying bid-ask spreads, asymmetric commissions, and market breakdowns. Discreteness, which imposes additional transaction costs, reduces the value of private information. Liquidity traders can benefit under certain conditions.Keywords
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