MARKET MAKING WITH DISCRETE PRICES

Exchange-mandated discrete pricing restrictions create a wedge between the underlying equilibrium price and the observed price This wedge pe rmits a competitive market maker to realize economic profits that coul d help recoup fixed costs. The optimal tick sire that maximizes the ex pected profits of the market matter can be equal to $1/8 for reasonabl e parameter values. The optimal tick, size is decreasing in the degree of adverse selection. Discreteness per se can cause time-varying bid- ask spreads, asymmetric commissions, and market breakdowns. Discretene ss, which imposes additional transaction costs, reduces the value of p rivate information. Liquidity traders can benefit under certain condit ions.