An individual who chooses to serve as a market-maker is assumed to optimize his position by setting a bid-ask spread which maximizes the difference between expected revenues received from liquidity-motivated traders and expected losses to informationmotivated traders. By characterizing the cost of supplying quotes, as writing a put and a call option to an information-motivated trader, it is shown that the bid-ask spread is a positive function of the price level and return variance, a negative function of measures of market activity, depth, and continuity, and negatively correlated with the degree of competition. Thus, the theory of information effects on the bid-ask spread proposed in this paper is consistent with the empirical literature.THIS PAPER IS CONCERNED with the determination of bid-ask spreads in organized financial markets, where the trading is done through economic agents who specialize in market-making for a limited set of securities. The commitment made by dealers to buy or sell at the bid and ask prices, respectively, is analyzed as a combination of put and call options, and empirical results published in previous works are shown to be consistent with the model.While there have been several papers concerned with the bid-ask spread, no entirely satisfactory theory has yet emerged. Demsetz [lo] was the first to formalize the problem. He treated the bid-ask spread as a (transaction) cost to the trader for immediacy, and analyzed it in a static supply and demand framework.Since Demsetz's seminal paper there have been two main lines of thought about the theory of the bid-ask spread and they are not necessarily antithetical. Several papers focus primarily on the relationship between the bid-ask spread and dealer inventory costs. However, with the exception of Ho and Stoll [19], none of them explains the bid-ask spread with competitive dealers.' Some of the studies' are based on the assumption that risk-averse specialists are not well diversified, although this is inconsistent with the dealers' common practice of sharing their risks through partnerships and pooling agreements.The second line of thought follows Bagehot [2].3 The dealer is assumed to face
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