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Inventories_and_Prices - Market Maker Inventories and Stock...

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Market Maker Inventories and Stock Prices Terrence Hendershott U.C. Berkeley Mark S. Seasholes U.C. Berkeley This Version March 3, 2006 * Abstract This paper examines daily inventory/asset price dynamics using 11 years of NYSE specialist data. The unique length and breadth of our sample enables the first longer horizon testing of market making inventory models—e.g., Grossman and Miller (1988). We confirm such models’ predictions that specialists’ positions are negatively correlated with past price changes and positively correlated with subsequent changes. A portfolio that is long stocks with the highest inventory positions and short stocks with the lowest inventory positions has returns of 0.10% and 0.33% over the following 1 and 5 days, respectively. These findings empirically validate the causal mechanism—liquidity supplier inventory—that underlies models linking liquidity provision and asset prices. Inventories complement past returns when predicting return reversals. A portfolio long high-inventory/low-return stocks and short low-inventory/high-return stocks yields 1.05% over the following 5 days. Order imbalances calculated from signing trades relative to quotes also predict reversals and are complementary to inventories and past returns. Finally, specialist inventories can be used to predict return continuations over a one-day horizon. Keywords: Market Maker, Inventory, Liquidity Provision JEL number: G12 G14 * We thank the New York Stock Exchange for providing data—especially Katharine Ross and Jennifer Chan. We thank Larry Glosten, Charles Jones, Rich Lyons, and Christine Parlour for helpful comments. Hendershott gratefully acknowledges support from the National Science Foundation. Part of this research was conducted while Hendershott was the visiting economist at the New York Stock Exchange. Contact information: Mark S. Seasholes, U.C. Berkeley–Haas School, 545 Student Services Bldg., Berkeley CA 94720-1900; Tel: 510-642-3421; Fax: 510-642- 4700; email: [email protected] 1
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1 Introduction Empirical studies linking liquidity provision to asset prices follow naturally from inventory models. Liquidity suppliers and market markers profit from providing immediacy to less patient investors but have limited inventory carrying and risk bearing capacity. Similarly, limits to arbitrage arguments rely on the idea that certain market participants accommodate buying or selling pressure. These liquidity suppliers/arbitrageurs only bear the risk of holding undiversified positions if they are compensated by favorable subsequent price movements. Thus, when inventories are large, liquidity suppliers have taken on risk and prices should subsequently reverse. 1 By identifying and studying the inventories of traders who are central to the trading process and whose primary roll is to provide liquidity—NYSE specialists—over an 11-year period this paper contributes to a deeper understanding of inventory/asset price dynamics. To focus on the longer horizons impacts of inventory we use daily inventory measures and eliminate bid-ask bounce by calculating returns using quote midpoints. The length of our sample en-
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Inventories_and_Prices - Market Maker Inventories and Stock...

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