Does the market maker stabilize the market?

Elsevier Science BV
Publication Type:
Journal Article
Physica A: Statistical Mechanics and its Applications, 2009, 388 (15-16), pp. 3164 - 3180
Issue Date:
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The market maker plays an important role in price formation, but his/her behavior and stabilizing impact on the market are relatively unclear, in particular in speculative markets. This paper develops a financial market model that examines the impact on market stability of the market maker, who acts as both a liquidity provider and an active investor in a market consisting of two types of boundedly rational speculative investorsâthe fundamentalists and trend followers. We show that the market maker does not necessarily stabilize the market when he/she actively manages the inventory to maximize profits, and that rather the market makerâs impact depends on the behavior of the speculators. Numerical simulations show that the model is able to generate outcomes for asset returns and market inventories that are consistent with empirical findings.
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