Monday, April 27, 2009

information-motivated and liquidity-motivated transactions (2)

In the absence of foolish investors,the very existence of a dealer market depends on investors desires for liquidity. A dealer must select a bid-ask spread wide enough to limit the number of trades with customers possessing superior information,but narrow enough to attract an adequate number of liquidity-motivated transactions.
A dealer can take either a passive or an active role.For example,a bid-ask spread can be established and a tentative price set. As orders come in and are filled,the dealer,s inventory (position)will vary and may even become negative when promises to deliver securities exceed promises to accept delivery. But any clear trend suggests that the price should be altered. In effect,a passive dealer lets the market indicate the appropriate price. An active dealer tries to get as much information as possible and to alter bid and ask prices advance to keep the flow of orders more in balance.The better a dealer,s information,the smaller the bid-ask spread required to make a profit. when there is competition among dealers,those who are not well informed either price themselves out of the market by requiring too high a bid-ask spread or go out of business after incurring heavy losses. In general,the interests of investors are best served by a market in which dealers with unlimited access to all sources of information compete with one another.

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