The optimal pricing of a market maker in a heterogeneous agent economy

Abstract

This paper extends some classical models, built upon the representative-agent and Walrasian market-clearing mechanism, into one characterized by a market-maker trading mechanism with investors having heterogeneous beliefs regarding the likely future payoff of a risky security. We show the optimal determination of the bid and ask prices and resultant trading volume. The endogenously-determined spread and volume are increasing with the degree of the heterogeneity of investors’ beliefs. We analyze the market marker’s risk exposure based on his inventory, under the condition in which he is fully informed of the investors’ beliefs, and under the condition in which he is not.