On the Feasibility of Automated Market
Making by a Programmed Specialist
Nils H. Hakansson, Avraham Beja, and Jivendra Kale
The Journal of Finance, 40, March 1985, 1-20.
Securities trading is accomplished through the execution of orders. Admissible orders
(e.g., market orders, limit orders) give rise to discontinuous aggregate demand
functions, composed of many "steps." Demand smoothing, or the balancing of excesses
due to such discontinuities via intervention, is one of the most basic functions that
could be assigned to a "specialist." When the specialist's "affirmative obligation"
is fully specified, his or her activity can in principle be automated. This paper is
an attempt to assess, via simulation, some of the ramifications of using a "programmed
specialist," whose automated market making is limited to demand smoothing. A number
of alternative rules of operation are simulated. Several of the rules performed well,
especially the extremely simple rule that calls for the (computerized) specialist to
minimize new absolute share holdings in each security at each trading point via "total"
(as opposed to "local") demand smoothing. Our results indicate that the underlying
costs of demand smoothing are on the order of a fraction of a penny per share traded
even in relatively thin markets.
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