Price Crashes, Information Aggregation, and Market-Making

Abstract

We present a model of market-making in which traders possess private and heterogeneous information, and the market-maker acts strategically to maximize profits. Thus, the market-maker must now consider that the prices he sets affect both the information he acquires (through the order flow) and the amount of aggregated information he releases back to the market. We show that the equilibrium price as a function of the order flow displays a discontinuity. This discontinuity can be interpreted as a price crash, since an arbitrarily small change in underlying market variables can lead to a large change in price. At this point, there is also a discontinuity in the information content of price.Journal of Economic LiteratureClassification Numbers: D82, D84, G14, G20. © 1997 Academic Press.