The Dynamics of Bid and Ask Quotes Set by a Heterogeneously Informed Market Maker

Abstract

This paper studies the effects superiorly informed market makers have on the price formation process. Two models are developed in which the market maker receives some informative signal. In one version, the market maker receives an informative signal at the start of the day with which he assigns a probability to its correctness. In the other version, the market maker receives a fully informative signal at some random time throughout the day. By comparing the models to the Glosten and Milgrom (1985) model, it is shown that informed market makers are able to improve certain dimensions of market quality. Prices become more reflective of their true value, price discovery is enhanced, and trading costs for uninformed traders are decreased. These benefits to the market are further demonstrated through the development of simulations of the theoretical models.