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An Analysis of Daily Changes in Specialist Inventories and Quotations

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  • Ananth Madhavan
  • Seymour Smidt

Abstract

This paper develops a model of market making that incorporates both inventory control and asymmetric information effects. We show that the specialist acts both as a market maker and as an active investor trading for his own account. As a market maker, the specialist quotes prices that induce mean reversion toward a desired level of inventory; as an active investor, he periodically adjusts the target inventory levels towards which inventories revert. We test the model using data obtained from a NYSE specialist. We find that specialist inventories exhibit mean reversion, but the adjustment process is slow, even controlling for shifts in target inventories. The model also predicts that quote revisions are negatively related to specialist trades and positively related to the information conveyed by order imbalances. We find strong evidence for this hypothesis; further, our results suggest that specialist quotes anticipate future order imbalances.

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Bibliographic Info

Paper provided by Wharton School Rodney L. White Center for Financial Research in its series Rodney L. White Center for Financial Research Working Papers with number 22-92.

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Handle: RePEc:fth:pennfi:22-92

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Cited by:
  1. Toni Gravelle, 1999. "The Market Microstructure of Dealership Equity and Government Securities Markets: How They Differ," CGFS Papers chapters, in: Bank for International Settlements (ed.), Market Liquidity: Research Findings and Selected Policy Implications, volume 11, pages 1-16 Bank for International Settlements.
  2. de Jong, Frank & Nijman, Theo & Roell, Ailsa, 1996. "Price effects of trading and components of the bid-ask spread on the Paris Bourse," Journal of Empirical Finance, Elsevier, vol. 3(2), pages 193-213, June.

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