Market Maker Inventories and Liquidity Terrence Hendershott Pamela C. Moulton Mark S. Seasholes* May 9, 2007 Abstract Traditional microstructure models predict that market makersâ 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 makerâs 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. http://www.fma.org/Orlando/Papers/CapConstraints_and_Liq.pdf
1) 1994 to 2004. That's ancient history. 2) Do the authors take derivative and hedge-related trading into account? 3) The chart on page-37 could be more "relevant" if it were overlayed against the S&P-500. 4) 38 pages! Thanks for almost curing me of my insomnia.
I like this paper... Somewhat counterintuitive conclusion, so will need to read a bit more carefully. Thx!