Quoting Activity and the Cost of Capital

Abstract

We study the quoting activity of market makers in relation to trading, liquidity, and expected returns. Empirically, we find larger quote-to-trade (QT) ratios in small, illiquid or neglected firms, yet large QT ratios are associated with low expected returns. The last result is driven by quotes, not by trades. We propose a model of quoting activity consistent with these facts. In equilibrium, market makers monitor the market faster (and thus increase the QT ratio) in neglected, difficult-to-understand stocks. They also monitor faster when their clients are more precisely informed, which reduces mispricing and lowers expected returns.

Keywords: Quote-to-trade ratio, market making, liquidity, price discovery, monitoring, information acquisition, neglected stocks, inventory, high frequency trading

JEL Classification: G12, G14, D82