Adverse Selection, Inventory Holding Costs, and Depth
Posted: 26 Jan 2000
We examine whether NYSE/AMEX depth quotes are related to the adverse-selection and inventory-holding-cost components of the spread. Consistent with theory predicting an inverse relation between depths and the risk of informed trading, we find that depth quotes are strongly inversely related to the adverse-selection component of the spread even after controlling for quoted spread. We also find depth quotes are inversely related to the inventory-holding-cost component, though this relation is weaker than the relation between depths and adverse selection. To the extent adverse selection and inventory holding cost estimates capture variation in informed trading and inventory holding risk, our evidence suggests that cross-sectional variation in depths is driven primarily by variation in the risk of informed trading, rather than inventory concerns.
JEL Classification: G10, G14
Suggested Citation: Suggested Citation