An Analysis of Changes in Specialist Inventories and Quotations

Ananth Madhavan and Seymour Smidt

Journal of Finance, 1993, vol. 48, issue 5, 1595-1628

Abstract: The authors develop a dynamic model of market-making incorporating inventory and information effects. The marketmaker is both a dealer and an investor, quoting prices that induce mean reversion in inventory toward targets determined by portfolio considerations. The authors test the model with inventory data from a New York Stock Exchange specialist. Specialist inventories exhibit slow mean reversion, with a half-life of over forty-nine days, suggesting weak inventory effects. However, after controlling for shifts in desired inventories, the half-life falls to seven and three-tenths days. Further, quote revisions are negatively related to specialist trades and are positively related to the information conveyed by order imbalances. Copyright 1993 by American Finance Association.

Date: 1993
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