Why Market Makers Should Consider the Outside Market Price
Summary
The note considers whether a market maker can set quotes using only inventory, volatility, and risk preferences, without reference to prices elsewhere. Its answer argues that external market prices matter because counterparties can trade against quotes that diverge from the broader market, potentially creating arbitrage for them and accumulating one-sided inventory for the market maker.
An example contrasts a market maker who estimates fair value at 100 with a market consensus near 90. Quoting around the maker’s estimate could leave it exposed to adverse selection, while quoting nearer the consensus may limit that exposure even if the maker still believes the asset is mispriced. The example illustrates a practical tension between private valuation and competitive pricing; it does not provide a formal model, empirical evidence, or a quantitative rule for setting quote offsets.
Key ideas
- Market makers face competitive pressure from prices quoted elsewhere.
- Quotes far from the market can attract trades that benefit counterparties and worsen inventory imbalance.
- A market maker may account for its own valuation while keeping quotes near the prevailing market.
- The example is conceptual and does not establish a precise quoting formula.
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Full text
# Market Making independent of outside market price # Market Making independent of outside market price Is it uncommon to provide liquidity in an asset without consideration of an outside market price? In other words, a market maker would set their bid ask quotes as a function of only their own inventory, asset volatility, risk tolerance, etc. and not what the broader market is quoting. If I'm reading the below papers correctly, it appears they both quote bid asks with respect to an outside market price. Dealing with the Inventory Risk https://www.math.nyu.edu/faculty/avellane/HighFrequencyTrading.pdf ## Answer by Attack68 (score 2) https://quant.stackexchange.com/a/48906 The existing (outside) market price must be a consideration to strategic market-maker. The reason being is due to competitive market influences. If you imagine a price-taker acting on the best competitive quote he may be able to secure an arbitrage if acting on an outlier price or the market-maker may simply execute trades in only a single direction thereby building up a particularly one-sided inventory. As an example, suppose that a market-maker believes the consensus price of 90 is wrong and in fact estimates the fair value at 100, then it would be foolish to quote prices of 98-102, whilst all others quote in the region of 88-92. Instead a better strategy would be to quote 90-94. That way the market-maker is still likely to build up a one-sided inventory but at a much more equitable market price.
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This summary was written by Stratmill's research agent from the original; it is not a copy of the source.