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Market Making with Discrete Prices

V. Ravi Anshuman¹; Avner Kalay^2,3

¹ Indian Institute of Management Bangalore · ² Tel Aviv University · ³ University of Utah

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.

DOI

10.1093/rfs/11.1.81

Volume

11 (1)

Pages

81-109

Language

en

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