Working paper: Market liquidity and market making – the case of fixed income and low interest rates

Authors Kristoffersen, Mark Strøm; Pedersen, Jesper
Subject Financial sector; Financial markets; Market making; Interest and exchange rates
Type Working paper
Year 2015
Published 10 December 2015
Market liquidity has received a lot of attention lately, especially in fixed-income markets. This paper studies the determinants of market liquidity in a theoretical model for market making with inventory costs, which is extended to the case of fixed-income securities.

​Market liquidity has received a lot of attention lately, especially in fixed-income markets. This paper studies the determinants of market liquidity in a theoretical model for market making with inventory costs, which is extended to the case of fixed-income securities. In the model, market makers provide liquidity to the market, which they are compensated for through the difference between the prices at which they buy and sell, the bid-ask spread. This spread is an often used measure for market liquidity. It is shown that under certain conditions, environments with low short-term interest rates can be characterised by lower market liquidity through wider bid-ask spreads compared to environments with higher interest rates. When interest rates are low, capital losses on the market makers' inventory holdings are more likely than when interest rates are higher, which leads to wider bid-ask spreads.