News at Smith

Fearless Idea 27: Limit Market-Making Risks

Mar 27, 2017
World Class Faculty & Research

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SMITH BRAIN TRUST — Market makers have significant influence in financial markets, and they take on significant risk. In new research, Yajun Wang, assistant professor of finance at the University of Maryland’s Robert H. Smith School of Business, helps build a market-making model that enables market participants to better understand those risks.

The model, developed by Wang and co-author Hong Liu from Washington University in St. Louis, differs from traditional models because it allows market makers to explore how uninformed market participants might react to a change in a bid or ask price. 

Market makers perform an important function in markets, by generally standing ready to buy and sell a particular security, at what’s agreed to be the fair market value, and providing crucial market liquidity. They typically turn a profit by playing the bid/ask spread, which is the difference between the price to buy and sell a security. Essentially, the market maker buys an asset at a bid price, offers to sell it at the ask price, or thereabouts, essentially making a market for that security and providing liquidity to the market. 

The profits they realize are generally relatively small, but it’s quick work and in mass volumes the sums add up. However, they can also lose money if the price of the security suddenly drops before they can sell it. 

The research may help explain why bid-ask spreads may shrink when one market player knows something that the other does not, a circumstance referred to as “information asymmetry.” The model also explores the effects of inventory risk. “You would think that when there is more information asymmetry, the dealer would want to increase the price difference between the bid and ask to keep their profit at a certain level. And that’s what the existing models find,” Wang says. 

But empirical evidence shows that the opposite can be  true, she says. The greater the information asymmetry, the narrower the bid-and-ask spread is. “That’s a puzzle for us,” Wang says. “The paper tries to explain this puzzle.” This can happen as market makers respond to an increase in their informational disadvantage by encouraging trade with uninformed traders through a reduction in the spread, making it cheaper for these uninformed investors to trade. 

Read more: Market making with asymmetric information and inventory risk, Journal of Economic Theory 163 (2016) 73–109.

Yajun Wang is an assistant professor of finance at the University of Maryland’s Robert H. Smith School of Business. She received her PhD in Finance from Washington University in St. Louis in 2011.

Research interests: Theoretical and empirical asset pricing, and market microstructure. Also, the effects of market frictions, such as margin requirements, information asymmetry, transaction costs, and imperfect competition on asset prices, market volatility, market illiquidity, and social welfare. 

Selected accomplishments: Research has appeared in the Review of Economic Studies,  Journal of Economic Theory, Management Science and Review of Finance. She has won 2013 TCFA Best Paper Award and 2014 TCW Best Paper Award.

About this series: The Smith School faculty is celebrating Women’s History Month 2017 in partnership with ADVANCE, an initiative to transform the University of Maryland by investing in a culture of inclusive excellence. Daily faculty spotlights support activities from the school’s Office of Diversity Initiatives, culminating with the sixth annual Women Leading Women forum on March 30, 2017.

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About the University of Maryland's Robert H. Smith School of Business 

The Robert H. Smith School of Business is an internationally recognized leader in management education and research. One of 12 colleges and schools at the University of Maryland, College Park, the Smith School offers undergraduate, full-time and part-time MBA, executive MBA, online MBA, specialty masters, PhD and executive education programs, as well as outreach services to the corporate community. The school offers its degree, custom and certification programs in learning locations in North America and Asia.