A model of market making with heterogeneous speculators

Abstract

I introduce an optimizing monopolistic market maker in an otherwise standard setting a la Brock and Hommes (1998) (BH98). The market maker manages her inventory of a zero yielding asset, such as foreign currency, and can earn profits from trading, taking advantage of her knowledge of speculators' demand. The resulting dynamic behavior is qualitatively identical to the one described in BH98, showing that the results of the latter are independent from the institutional framework of the market. At the same time I show that the market maker has conflicting effects. She acts as a stabilizer when she allows for market imbalances, while she acts as a destabilizer when she manages aggressively her inventories and when she trades actively, both if she acts as fundamentalist or if she is a strong extrapolator. Indeed the more stable institutional framework is one in which market makers are inventory neutral and don't trade actively but, even in this case, the typical complex behavior of BH98 occurs.

Market structure or agent rationality: How efficiency trades with belief updating?

“…At the same time, Naimzada and Ricchiuti (2014) show that belief heterogeneity can have a positive effect on price stability if the market maker adopts a multiplicative price setting mechanism. Such an ambiguous relationship between individual characteristics, market structure, and aggregate outcomes also emerges from the analysis of Bargigli (2021), where an optimizing monopolistic market maker is assumed in an otherwise standard model à la Brock and Hommes (1998).…”