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

Table of Contents

• Introduction
• What drives Inventory?
  • Capital Constraints
  • Liquidity
  • Volatility
• How does Inventory drive Liquidity?
  • Inventory and Liquidity
  • Impact on the Bid-Ask Spread
  • Summary
• How does Inventory affect Asset Prices?
  • Theory
  • Empirical Results
  • Summary
• Changes in Market Structure
  • Dilution in the Role of Market Makers/Dealers
  • Technological Advances and High Frequency Traders

Objectives and Key Themes

This thesis provides a survey of inventory control models and their empirical results regarding the role of inventory in price formation, focusing primarily on the New York Stock Exchange (NYSE) and the National Association of Securities Dealers (NASDAQ). It examines how inventory influences liquidity and asset prices, considering factors such as capital constraints, liquidity, and volatility.

• The impact of market maker inventory on price formation.
• The role of capital constraints, liquidity, and volatility in driving inventory levels.
• The relationship between market maker inventory and liquidity, specifically its effect on the bid-ask spread.
• The influence of changes in market structure on traditional market makers and their inventories.
• An overview of existing theoretical and empirical research on inventory control models.

Chapter Summaries

Introduction: This chapter introduces the topic of market microstructure and the role of market makers, focusing on inventory control models. It distinguishes between inventory control models and asymmetric information models, highlighting the importance of inventory in price formation, particularly during times of market stress. The chapter establishes the thesis's scope, concentrating on inventory control models and their application to the NYSE and NASDAQ, laying out the structure of the following sections.

What drives Inventory?: This chapter delves into the factors influencing market maker inventory levels. It examines capital constraints, arguing that market makers face upper and lower inventory limits due to risk aversion and institutional or self-imposed restrictions. The chapter explores how higher inventory levels increase financing costs due to increased insolvency risk and how this impacts a market maker’s ability to hold inventory for extended periods, necessitating daily position offsets. The influence of margins and funding liquidity risk on inventory adjustments is also discussed, showing how increased margins reduce available capital and force inventory reductions.

How does Inventory drive Liquidity?: This chapter explores the effects of market maker inventory on liquidity and the bid-ask spread. It examines how inventory costs impact liquidity provision and discusses the mechanisms through which inventory levels influence the spread. The chapter synthesizes the relationship between inventory management, liquidity provision, and the pricing of assets, emphasizing the cost-benefit analysis for market makers in maintaining optimal inventory levels for efficient trading.

How does Inventory affect Asset Prices?: This chapter focuses on the direct impact of market maker inventory levels on asset prices. It presents theoretical models and empirical findings that demonstrate the relationship between inventory levels and price fluctuations. The chapter will likely analyze the dynamics of how inventory adjustments affect market equilibrium and price discovery, with likely case studies illustrating significant price impacts driven by changes in market maker inventory.

Changes in Market Structure: This chapter discusses how shifts in market structure, such as the rise of high-frequency trading and the increased use of dark pools, have altered the traditional role of market makers and their inventory management practices. It explores the implications of these changes for market liquidity and price discovery, likely providing evidence of how technological advancements and new market participants have reshaped the dynamics of inventory control and its effects on market function.

Keywords

Market microstructure, market makers, inventory control, bid-ask spread, liquidity, asset prices, capital constraints, volatility, high-frequency trading, dark pools, NYSE, NASDAQ.

Frequently Asked Questions: A Comprehensive Language Preview

What is the purpose of this thesis?

This thesis provides a comprehensive overview of inventory control models and their empirical effects on price formation, primarily focusing on the New York Stock Exchange (NYSE) and the National Association of Securities Dealers Automated Quotation system (NASDAQ). It investigates how inventory influences liquidity and asset prices, considering factors like capital constraints, liquidity, and volatility.

What are the key themes explored in the thesis?

The main themes include the impact of market maker inventory on price formation; the role of capital constraints, liquidity, and volatility in driving inventory levels; the relationship between market maker inventory and liquidity (especially its effect on the bid-ask spread); the influence of market structure changes on traditional market makers and their inventories; and an overview of existing theoretical and empirical research on inventory control models.

What factors drive market maker inventory levels?

The thesis examines capital constraints, explaining how market makers face upper and lower inventory limits due to risk aversion and institutional or self-imposed restrictions. It also explores how higher inventory levels increase financing costs (due to increased insolvency risk), impacting a market maker's ability to hold inventory long-term. The influence of margins and funding liquidity risk on inventory adjustments is discussed, showing how increased margins reduce available capital and force inventory reductions.

How does market maker inventory affect liquidity and the bid-ask spread?

The thesis explores how inventory costs impact liquidity provision and the mechanisms through which inventory levels influence the bid-ask spread. It synthesizes the relationship between inventory management, liquidity provision, and asset pricing, emphasizing the cost-benefit analysis for market makers in maintaining optimal inventory levels for efficient trading.

What is the direct impact of market maker inventory on asset prices?

This section presents theoretical models and empirical findings demonstrating the relationship between inventory levels and price fluctuations. It analyzes how inventory adjustments affect market equilibrium and price discovery, potentially including case studies illustrating significant price impacts driven by changes in market maker inventory.

How have changes in market structure affected market makers and their inventory management?

The thesis discusses how shifts in market structure (such as the rise of high-frequency trading and increased use of dark pools) have altered the traditional role of market makers and their inventory management practices. It explores the implications of these changes for market liquidity and price discovery, providing evidence of how technological advancements and new market participants have reshaped the dynamics of inventory control and its effects on market function.

What is the structure of the thesis?

The thesis is structured with an introduction, followed by chapters on what drives inventory, how inventory drives liquidity, how inventory affects asset prices, and finally, changes in market structure. Each chapter includes a summary.

What are the keywords associated with this thesis?

Key words include market microstructure, market makers, inventory control, bid-ask spread, liquidity, asset prices, capital constraints, volatility, high-frequency trading, dark pools, NYSE, and NASDAQ.