Do Dealer Firms Manage Inventory on a Stock-by-Stock or a Portfolio Basis?

Abstract

This paper investigates whether dealer firms' trading and pricing decisions are governed by their equivalent inventories, based on total returns as in Ho and Stoll (1983) or on unhedgeable returns as in Froot and Stein (1998), or by their ordinary inventories, as would be the case in a decentralized market-making organisational structure. It finds that ordinary inventories, and not equivalent inventories best explain dealer firms' quote placement strategy, which dealer firm executes trades and the quality of execution offered to the trades. This finding is consistent with decentralized market making where, due to information sharing difficulties or the nature of compensation contracts, individual dealers care only about risk of stocks managed by them, and not the positions of other dealers within the firm.

Keywords: Dealer firm, equivalent inventory, correlated risk exposure, unhedgeable risk, effective spreads

JEL Classification: G12, G20, G24