RISK ALLOCATION AND INTER-DEALER TRADING

This paper contrasts an auction and a dealership market, In the latter , parallel to the public market, market makers are allowed to trade wi th each other in a separate inter-dealer market. Since market makers a re assumed to be risk averse, variations in asset holdings induced by trades with outside investors generate portfolio hedging trade. We fin d that the price at which market makers trade with each other in the i nter-dealer market determines the prices quoted in the public market f or outside investors. It is shown that an investor gets a better price in the dealership market as long as the market makers and speculators are imperfectly competitive and the delay between executing the custo mer's order and trading in the inter-dealer market is not too large.