Order Flows and Stock Returns: Compensation for Market Makers with Inventory Concerns

Financial Review, Forthcoming

36 Pages Posted: 16 Mar 2011 Last revised: 15 Jul 2014

See all articles by Moonsoo Kang

Moonsoo Kang

CUNY Brooklyn College

Bong‐Soo Lee

Florida State University

Date Written: November 30, 2013

Abstract

We investigate whether market makers with inventory concerns are compensated with subsequent monthly returns in the cross-section. We find a significant negative relation between order flows and monthly returns, “the order flow effect”, suggesting that market makers lower prices for stocks with sell order flows and demand a reward in the form of higher expected returns. Further, the order flow effect is stronger for high-volatility or high-volume stocks for which market makers have serious inventory concerns. Funding liquidity of market makers also affects the order flow effect. Finally, our finding is independent of existing regularities and robust to the decimalization.

Keywords: Order flow, Market maker, Inventory concerns

JEL Classification: G10, G14

Suggested Citation

Kang, Moonsoo and Lee, Bong Soo, Order Flows and Stock Returns: Compensation for Market Makers with Inventory Concerns (November 30, 2013). Financial Review, Forthcoming, Available at SSRN: https://ssrn.com/abstract=1787760 or http://dx.doi.org/10.2139/ssrn.1787760

Moonsoo Kang (Contact Author)

CUNY Brooklyn College ( email )

2900 Bedford Avenue
Brooklyn, NY 11210
United States

Bong Soo Lee

Florida State University ( email )

Tallahasse, FL 32306
United States

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