Quoting Activity and the Cost of Capital
53 Pages Posted: 24 Jul 2017 Last revised: 21 Dec 2018
Date Written: December 21, 2018
We study how market makers set their quotes in relation to trading, liquidity, and expected returns. In our model, market makers in neglected, difficult-to-understand stocks monitor the market more often, thus increasing their quote-to-trade (QT) ratio. They also monitor more often when their clients are more precisely informed, which reduces mispricing and lowers expected returns. Consistent with our model, large QT ratios are empirically associated with low expected returns, a result driven by quotes, not by trades. Moreover, more market makers are associated with smaller QT ratios, but have no effect on the cost of capital.
Keywords: Quote-to-trade ratio, market making, liquidity, price discovery, monitoring, information acquisition, neglected stocks, inventory, high frequency trading
JEL Classification: G12, G14, D82
Suggested Citation: Suggested Citation