An Analysis of Daily Changes in Specialist Inventories and Quotations

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Abstract
This paper develops a model of market making that incorporates both inventory control and asymmetric information effects. We show that the specialist acts both as a market maker and as an active investor trading for his own account. As a market maker, the specialist quotes prices that induce mean reversion toward a desired level of inventory; as an active investor, he periodically adjusts the target inventory levels towards which inventories revert. We test the model using data obtained from a NYSE specialist. We find that specialist inventories exhibit mean reversion, but the adjustment process is slow, even controlling for shifts in target inventories. The model also predicts that quote revisions are negatively related to specialist trades and positively related to the information conveyed by order imbalances. We find strong evidence for this hypothesis; further, our results suggest that specialist quotes anticipate future order imbalances.
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