Correlated Portfolio Inventory Risk of Liquidity Providers: Frictions and Market Fragility

46 Pages Posted: 22 Sep 2020 Last revised: 15 Sep 2021

See all articles by Roman Kozhan

Roman Kozhan

University of Warwick - Warwick Business School

Vikas Raman

Lancaster University - Department of Accounting and Finance

Pradeep K. Yadav

University of Oklahoma Price College of Business

Date Written: February 1, 2021

Abstract

We investigate, for limit order book equity markets, how trading, liquidity provision, and the overall market quality in one security are influenced by correlated inventory risk exposures of liquidity providers to other securities in their portfolios. We find strong support for Ho and Stoll (1983). Our results are also consistent with large and correlated portfolio inventories worsening different measures of market quality – including bid-ask spreads and pricing errors – and increasing the number and likelihood of extreme price movements and transitory jumps in stock returns. We accordingly highlight a significant but often overlooked source of market frictions, contagion, and fragility.

Keywords: Inventory Management, Limit Order Markets, Market Quality

JEL Classification: G12, G20, G24

Suggested Citation

Kozhan, Roman and Raman, Vikas and Yadav, Pradeep K., Correlated Portfolio Inventory Risk of Liquidity Providers: Frictions and Market Fragility (February 1, 2021). Available at SSRN: https://ssrn.com/abstract=3669329 or http://dx.doi.org/10.2139/ssrn.3669329

Roman Kozhan (Contact Author)

University of Warwick - Warwick Business School ( email )

Coventry CV4 7AL
United Kingdom

Vikas Raman

Lancaster University - Department of Accounting and Finance ( email )

The Management School
Lancaster LA1 4YX
United Kingdom

Pradeep K. Yadav

University of Oklahoma Price College of Business ( email )

307 W.Brooks, Room 3270 Division of Finance
Norman, OK 73019
United States
4053255591 (Phone)
4053255491 (Fax)

HOME PAGE: http://www.ou.edu/price/finance/faculty/pradeep_yadav.html

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