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Who makes market

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  • Joon Chae
  • Albert Wang
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    Abstract

    We explore the role of dealers to determine whether they are liquidity-providing market makers or liquidity-taking information traders. Standard models of market making, such as Kyle (1985) and Grossman and Miller (1988), imply a negative contemporaneous correlation between market maker order flow and stock returns. We test this relation with a unique dataset containing trades of all dealers in a well-developed, liquid market. The correlation is strongly positive, implying that dealers take liquidity. We also develop a unique profit decomposition to compare intraweek information and market making profits. Dealers earn significant excess returns, in aggregate driven by information rather than market making. Subgroup analysis reveals that information profits are positive and increasing in stock capitalization, and market making returns are positive and significant for all but the largest stocks

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    File URL: http://repec.org/esFEAM04/up.12019.1080513148.pdf
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    Bibliographic Info

    Paper provided by Econometric Society in its series Econometric Society 2004 Far Eastern Meetings with number 605.

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    Date of creation: 11 Aug 2004
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    Handle: RePEc:ecm:feam04:605

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    Keywords: Dealer; Liquidity Provision;

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    1. J. Bradford De Long & Andrei Shleifer & Lawrence H. Summers & Robert J. Waldmann, 1989. "Positive Feedback Investment Strategies and Destabilizing Rational Speculation," NBER Working Papers 2880, National Bureau of Economic Research, Inc.
    2. Katrina Ellis & Roni Michaely & Maureen O'Hara, 2002. "The Making of a Dealer Market: From Entry to Equilibrium in the Trading of Nasdaq Stocks," Journal of Finance, American Finance Association, vol. 57(5), pages 2289-2316, October.
    3. Grossman, Sanford J & Stiglitz, Joseph E, 1980. "On the Impossibility of Informationally Efficient Markets," American Economic Review, American Economic Association, vol. 70(3), pages 393-408, June.
    4. Grossman, Sanford J & Miller, Merton H, 1988. " Liquidity and Market Structure," Journal of Finance, American Finance Association, vol. 43(3), pages 617-37, July.
    5. Seppi, Duane J, 1997. "Liquidity Provision with Limit Orders and a Strategic Specialist," Review of Financial Studies, Society for Financial Studies, vol. 10(1), pages 103-50.
    6. Gerard Gennotte and Hayne Leland., 1989. "Market Liquidity, Hedging and Crashes," Research Program in Finance Working Papers RPF-184, University of California at Berkeley.
    7. Hasbrouck, Joel, 1991. " Measuring the Information Content of Stock Trades," Journal of Finance, American Finance Association, vol. 46(1), pages 179-207, March.
    8. Kyle, Albert S, 1985. "Continuous Auctions and Insider Trading," Econometrica, Econometric Society, vol. 53(6), pages 1315-35, November.
    9. Ho, Thomas S Y & Macris, Richard G, 1984. " Dealer Bid-Ask Quotes and Transaction Prices: An Empirical Study of Some AMEX Options," Journal of Finance, American Finance Association, vol. 39(1), pages 23-45, March.
    10. Wang, Jiang, 1994. "A Model of Competitive Stock Trading Volume," Journal of Political Economy, University of Chicago Press, vol. 102(1), pages 127-68, February.
    11. Chan, Louis K C & Lakonishok, Josef, 1995. " The Behavior of Stock Prices around Institutional Trades," Journal of Finance, American Finance Association, vol. 50(4), pages 1147-74, September.
    12. Madhavan, Ananth & Smidt, Seymour, 1993. " An Analysis of Changes in Specialist Inventories and Quotations," Journal of Finance, American Finance Association, vol. 48(5), pages 1595-1628, December.
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