Market Making with Asymmetric Information and Inventory Risk∗

Market makers in over-the-counter markets often make offsetting trades and have significant market power. We develop a market making model that captures these market features as well as other important characteristics such as information asymmetry and inventory risk. In contrast to the existing literature, a market maker in our model can optimally shift some trade with the informed to other discretionary investors by adjusting bid or ask. As a result, we find that consistent with empirical evidence, expected bid-ask spreads may decrease with information asymmetry and bid-ask spreads can be positively correlated with trading volume