The Mathematics of Financial Modelingand Investment Management

2-Financial Markets Page 30 Wednesday, February 4, 2004 1:15 PM

30 The Mathematics of Financial Modeling and Investment Management

The bid-ask spread can be viewed in turn as the price charged by dealers

for supplying immediacy, together with short-run price stability (continu-

ity or smoothness) in the presence of short-term order imbalances. There

are two other roles that dealers play: they provide better price informa-

tion to market participants, and in certain market structures they provide

the services of an auctioneer in bringing order and fairness to a market.^5

The price-stabilization role relates to our earlier example of what

may happen to the price of a particular transaction in the absence of

any intervention when there is a temporary imbalance of order. By tak-

ing the opposite side of a trade when there are no other orders, the

dealer prevents the price from materially diverging from the price at

which a recent trade was consummated.

Investors are concerned with immediacy, and they also want to

trade at prices that are reasonable, given prevailing conditions in the

market. While dealers cannot know with certainty the true price of a

security, they do have a privileged position in some market structures

with respect to the flow of market orders. They also have a privileged

position regarding “limit” orders, the special orders that can be exe-

cuted only if the market price of the security changes in a specified way.

Finally, the dealer acts as an auctioneer in some market structures,

thereby providing order and fairness in the operations of the market.

For example, the market maker on organized stock exchanges in the

United States performs this function by organizing trading to make sure

that the exchange rules for the priority of trading are followed. The role

of a market maker in a call market structure is that of an auctioneer.

The market maker does not take a position in the traded security, as a

dealer does in a continuous market.

One of the most important factors that determine the price dealers

should charge for the services they provide (i.e., the bid-ask spread) is

the order processing costs incurred by dealers, such as the costs of

equipment necessary to do business and the administrative and opera-

tions staff. The lower these costs, the narrower the bid-ask spread. With

the reduced cost of computing and better-trained personnel, these costs

have declined over time.

Dealers also have to be compensated for bearing risk. A dealer’s

position may involve carrying inventory of a security (along position) or

(^3) George Stigler, “Public Regulation of Securities Markets,” Journal of Business
(April 1964), pp. 117–34.
(^4) Harold Demsetz, “The Cost of Transacting,” Quarterly Journal of Economics
(October 1968), pp. 35–6.
(^5) Robert A. Schwartz, Equity Markets: Structure, Trading, and Performance (New
York: Harper & Row Publishers, 1988), pp. 389–397.