The Microeconomics of Market Making

This paper examines the influence of risk aversion on the pricing policies of a market maker for securities. It is shown that a market maker's bid-ask spread can be decomposed into a portion for the known limit orders, a risk-neutral adjustment for expected market orders, and a risk adjustment for market order and inventory value uncertainty. It is demonstrated that a risk-averse market maker may set a smaller spread than a risk-neutral specialist. Finally, this paper demonstrates the pervasive role of inventory in affecting both the placement and size of the spread.