Market Maker

A designated market maker (specialist) on an exchange is responsible for:

1. A.Underwriting all new issuesUnderwriting is primary-market investment banking work, performed by syndicate members under an agreement with the issuer. The DMM operates in the secondary market, in securities that already trade.
2. B.Auditing listed companiesAudits are performed by independent public accountants, not by a trading participant. A firm quoting and trading the same stock it had audited would sit in an obvious conflict, which is why the functions are kept apart.
3. C.Maintaining a fair and orderly market in assigned securitiesCorrect - orderly-market obligation.
4. D.Setting Federal Reserve policyMonetary policy is set by the Federal Reserve Board and the FOMC, which have no role on an exchange trading floor. This confuses a market participant with a central bank.

Why: The DMM maintains a fair and orderly market in its assigned securities.

A market maker quotes a stock 32.10 bid, 32.40 ask. A customer enters a market order to sell 100 shares. At what price does the customer sell?

1. A.The last reported sale priceThe last sale shows where the stock traded previously, not where the market maker is currently willing to buy.
2. B.32.10Correct. The bid is the price the market maker pays, so a customer selling at the market receives 32.10.
3. C.32.25The midpoint is not a tradable price against a market maker's quote. Market orders execute at the bid or the ask.
4. D.32.40This is the ask, the price a customer would pay to buy. Selling at the ask reverses the two sides of the quote.

Why: The bid is the price at which the market maker will buy, so a customer selling into that quote receives the bid of 32.10. The ask is what a customer would pay to buy.

The difference between a security's bid and its ask is best understood as which of the following?

1. A.The market maker's gross compensation and an indicator of liquidityCorrect. The dealer earns the spread for making a two-sided market, and narrower spreads generally mean greater liquidity.
2. B.The expected daily price movement of the securityThis confuses the spread with volatility. The spread is a quote width, not a forecast of price change.
3. C.The commission the customer's broker chargesCommissions are agency compensation charged separately. The spread belongs to the dealer making the market.
4. D.A regulatory transaction fee collected by the exchangeExchange and regulatory fees are separate line items. They are not the bid-ask difference.

Why: The spread is the market maker's gross compensation for standing ready to buy and sell, and it is also a rough measure of how liquid the security is. Narrow spreads signal active trading.

A firm that maintains an inventory in a security and quotes continuous two-sided bid and ask prices is functioning as a:

1. A.Broker acting as agentWrong. A broker matches a customer with the other side and charges a commission. It does not carry inventory or quote its own prices.
2. B.CustodianWrong. A custodian safekeeps assets. It does not commit capital or quote prices.
3. C.Market makerCorrect. Quoting continuous two-sided markets from its own inventory is the definition of a market maker, which trades as principal.
4. D.Transfer agentWrong. The transfer agent keeps the issuer ownership records and never quotes or trades securities.

Why: That is a market maker. It commits capital to stand ready to buy at its bid and sell at its ask, providing liquidity and acting as principal in each trade.