Market-Maker

Definition of Market-Maker

A Market-Maker is a financial intermediary that provides liquidity to a market by being willing to buy and sell financial instruments at any time. They quote buy and sell prices (the bid and ask prices) to facilitate trading and profit from the spread between these prices.

Roles and Functions of Market-Makers

Market-makers play a crucial role in ensuring the stability and efficiency of financial markets. Their main functions include:

• Providing Liquidity: By consistently quoting prices at which they will buy or sell, market-makers ensure that there is always a market for buyers and sellers.
• Reducing Volatility: Their constant presence in the market helps to smooth out price fluctuations, thereby reducing volatility.
• Profit from Spreads: Market-makers capture profits by trading on the difference between the bid and ask prices.
• Facilitating Transactions: They enable trades between buyers and sellers without the need for direct interaction between the two parties.

How Market-Makers Operate

Market-makers continuously provide bid and ask prices for the securities they cover. For example:
– The bid price is the price at which the market-maker is willing to buy a security.
– The ask price is the price at which the market-maker is willing to sell the same security.

The difference between the ask and bid price is known as the spread.

Example of a Market-Maker in Action

Consider a market for a stock, XYZ. A market-maker might quote the following prices:
– Bid price: $50
– Ask price: $52

In this scenario, the market-maker offers to buy shares of XYZ at $50 (bid) and sell shares at $52 (ask). The spread is $2.

Calculation of Spread and Profit

To understand how market-makers earn profits, consider an example where they facilitate trades:
– If the market-maker buys 100 shares of XYZ at the bid price of $50, their cost is:

Cost = Number of Shares × Bid Price
= 100 shares × $50/share
= $5,000

– If they then sell those shares at the ask price of $52, their revenue is:

Revenue = Number of Shares × Ask Price
= 100 shares × $52/share
= $5,200

– The profit from this transaction would be the difference between revenue and cost:

Profit = Revenue – Cost
= $5,200 – $5,000
= $200

This example illustrates how market-makers earn a profit through the bid-ask spread by facilitating transactions between buyers and sellers, earning small amounts on many trades. Their continuous activity enhances market liquidity and efficiency.