The Role of Market-Maker/Dealer Inventories in the Price Formation Process

A Survey

Bachelor Thesis , 2015 , 34 Pages , Grade: 1,3

Business economics - Economic Policy

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.

Contents

List of Figures

List of Abbreviations

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
3.2. Impact on the Bid-Ask Spread
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

Bibliography

• College: University of Frankfurt (Main) (Faculty of Economics and Business Administration)
• Course: Chair of Corporate Finance
• Grade: 1,3
• Author: Evelyn Rill (Author)
• Publication Year: 2015
• Pages: 34
• Catalog Number: V309403
• ISBN (eBook): 9783668080300
• ISBN (Book): 9783668080317
• Language: English
• Tags: Market Microstructure, Market Making, Price Formation, Inventory Control