Market Maker Inventories and Liquidity

38 Pages Posted: 9 Nov 2006

See all articles by Terrence Hendershott

Terrence Hendershott

University of California, Berkeley - Haas School of Business

Pamela C. Moulton

Cornell University - SC Johnson College of Business

Mark S. Seasholes

ASU WP Carey School of Business

Date Written: May 9, 2007

Abstract

Traditional microstructure models predict that market makers' inventory positions do not impact liquidity (the effective cost of trading). Models with limited market maker riskbearing capacity predict that larger inventories negatively impact overall liquidity and the effect is greater for more volatile stocks. Using 11 years of NYSE specialists' inventory data, this paper tests these theoretical predictions. We find that larger inventory positions lead to lower liquidity both at the market level and at the market maker's firm level. We also find that the impact of inventories is larger for the liquidity of high-volatility stocks and for smaller market making firms. Finally, we confirm a prediction of models both with and without limited risk-bearing capacity: Inventory positions affect the relative liquidity for stock buyers versus sellers.

Keywords: inventory, market makers, capital constraints

JEL Classification: G12, G14

Suggested Citation

Hendershott, Terrence J. and Moulton, Pamela C. and Seasholes, Mark S., Market Maker Inventories and Liquidity (May 9, 2007). AFA 2008 New Orleans Meetings Paper. Available at SSRN: https://ssrn.com/abstract=943753 or http://dx.doi.org/10.2139/ssrn.943753

Terrence J. Hendershott

University of California, Berkeley - Haas School of Business ( email )

545 Student Services Building, #1900
2220 Piedmont Avenue
Berkeley, CA 94720
United States

Pamela C. Moulton (Contact Author)

Cornell University - SC Johnson College of Business ( email )

Ithaca, NY 14853
United States

Mark S. Seasholes

ASU WP Carey School of Business ( email )

Dept of Finance, BAC 501
400 E. Lemon St.
Tempe, AZ 85287-3906
United States

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