Due to the importance of inventories and the fact that asymmetric information models are extensively discussed in literature, this thesis exclusively focuses on inventory control models and provides a survey of theory and empirical results on the role of inventory in the price formation process. Because most of the relevant literature is based on the U.S. exchange market, this thesis is mainly confined on inventory control of specialists on the New York Stock Exchange (NYSE) and of dealers on the National Association of Securities Dealers (NASDAQ).
To understand the costs of holding inventory, Section 2 introduced three important drivers of inventory: capital constraints, liquidity and volatility. Section 3 summarises the effect of market maker inventory and its costs on liquidity and how this affects the bid-ask spread. In Section 4, the impact of inventory on asset prices, especially of inventory levels, is discussed in more detail. Section 5 briefly turns to changes in market structure and how they affect the role of traditional market makers and their inventories. Section 6 finally concludes.
Table of Contents
1 Introduction
2 What drives Inventory?
2.1. Capital Constraints
2.2. Liquidity
2.3. Volatility
3 How does Inventory drive Liquidity?
3.1. Inventory and Liquidity
3.1.1. Theory
3.1.2. Empirical Results
3.2. Impact on the Bid-Ask Spread
3.2.1. Theory
3.2.2. Empirical Results
3.3. Summary
4 How does Inventory affect Asset Prices?
4.1. Theory
4.2. Empirical Results
4.3. Summary
5 Changes in Market Structure
5.1. Dilution in the Role of Market Makers/Dealers
5.2. Technological Advances and High Frequency Traders
6 Conclusion
Objectives and Research Themes
This thesis examines the role of market maker inventories within the price formation process, focusing on the U.S. exchange market. The research objective is to analyze how inventory management by specialists and dealers affects liquidity, bid-ask spreads, and asset prices, while accounting for contemporary structural shifts in financial markets.
- Drivers of market maker inventory (capital constraints, liquidity, and volatility).
- The relationship between inventory accumulation, liquidity provision, and bid-ask spreads.
- The impact of inventory levels on asset prices and market stability.
- Structural transformations in markets, including the rise of electronic trading and High Frequency Traders (HFTs).
Excerpt from the Book
3.2. Impact on the Bid-Ask Spread
Demsetz (1968) was one of the first who modelled the bid-ask spread as compensation for the market maker to provide immediacy service and to bear price risk. Smidt (1971) and Tinic (1972) agree that the spread is determined by the cost of providing liquidity. Therefore, inventory holding costs as described in section 3.1 do not only affect liquidity but also the bid-ask spread. Smidt (1971) argues that when there is high liquidity in depth, which means that large transaction size can be traded, prices are stable and the spread is narrow. Ensuing, when the spread is narrow the market tends to be more liquid and continuous trading is possible. Tinic (1972) also points out that bid-ask spreads are narrower for actively traded stocks and wider for inactive stocks. He shows that when holding costs increase the market maker is less willing to provide liquidity and therefore widens the spread. Consequently, the spread can be interpreted as measurement of liquidity. Shen and Starr (2002) argue that the bid-ask spread is determined by the market maker inventory financing costs to provide liquidity. With larger inventory financiers increase cost due to higher insolvency risk and therefore the spread widens and liquidity declines. Lo, Mamaysky and Wang (2004) agree that if there is illiquidity in the market the spread increases to compensate the market maker for higher holding risk.
Summary of Chapters
1 Introduction: Provides an overview of market microstructure and the fundamental role of market makers in providing liquidity.
2 What drives Inventory?: Analyzes the key factors influencing inventory levels, specifically capital constraints, liquidity, and volatility.
3 How does Inventory drive Liquidity?: Explores the theoretical and empirical links between inventory management, liquidity provision, and the resulting bid-ask spreads.
4 How does Inventory affect Asset Prices?: Discusses classic inventory control theories and empirical findings regarding the impact of inventory on asset prices and price stability.
5 Changes in Market Structure: Examines the evolution of market structures, the diminishing role of traditional market makers, and the impact of technological advances like HFTs.
6 Conclusion: Synthesizes the main findings regarding the role of inventory and the ongoing shifts in financial market dynamics.
Keywords
Market Microstructure, Market Maker, Inventory Control, Liquidity, Bid-Ask Spread, Asset Prices, Capital Constraints, Price Volatility, High Frequency Traders, Algorithmic Trading, Financial Markets, Interdealer Trading, Price Discovery, Market Stability, Flash Crash
Frequently Asked Questions
What is the primary focus of this thesis?
The thesis focuses on the role of market maker inventories in the price formation process within the U.S. exchange market, specifically utilizing inventory control models.
What are the central themes discussed in the work?
The central themes include the drivers of inventory, the influence of inventory on liquidity and bid-ask spreads, the effect of inventory levels on asset prices, and the structural changes in markets due to technological advancements.
What is the core research objective?
The core objective is to provide a comprehensive survey of the theory and empirical evidence on how inventory management by market makers impacts the overall function and stability of financial markets.
Which scientific methods were employed?
The work employs a literature-based survey method, synthesizing existing academic theories and empirical studies on market microstructure.
What does the main body cover?
The main body covers the drivers of inventory, the relationship between inventory and liquidity/spreads, the link between inventory and asset prices, and the transition from human-intermediated markets to computer-intermediated markets.
Which keywords best characterize this work?
Market microstructure, inventory control, liquidity, bid-ask spread, asset prices, and high-frequency trading.
How do capital constraints affect market maker behavior?
Capital constraints limit a market maker's ability to accumulate inventory, forcing them to adjust positions more frequently and potentially reducing their willingness to provide liquidity, especially during times of high volatility.
Why are bid-ask spreads wider for less active stocks?
Spreads are wider for inactive stocks because the market maker faces higher holding costs and greater risk, necessitating a higher compensation for providing liquidity compared to actively traded stocks.
How did the Flash Crash of 2010 impact the understanding of inventory control?
The event highlighted the fragility of liquidity when market makers, overwhelmed by large order imbalances, are either unable or unwilling to accumulate further inventory, leading to rapid price declines.
- Citation du texte
- Evelyn Rill (Auteur), 2015, The Role of Market-Maker/Dealer Inventories in the Price Formation Process, Munich, GRIN Verlag, https://www.grin.com/document/309403
