Intertemporal price discovery by market makers: Active versus passive learning

Abstract

This paper demonstrates that market makers have the ability and incentive to facilitate price discovery in securities markets. Market makers can expedite the process of intertemporal price formation by setting prices to induce statistically more informative order flow. Such actions constitute an investment in the production of information. Under certain conditions, market makers can recoup the cost of this investment by making better pricing decisions in the future with more precise information. These conditions are analyzed in a general model and several examples that illustrate the complex nature of price discovery are presented.