Affirmative Obligations and Market Making with Inventory

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Abstract
Existing empirical studies provide little support for the theoretical prediction that market makers rebalance their inventory through revisions of quoted prices. In contrast, this study provides evidence that the specialist does engage in significant inventory rebalancing, but only when not constrained by the affirmative obligation to provide liquidity imposed by the NYSE's Price Continuity rule. The evidence also suggests that specialist affirmative obligations are associated with better market quality, but impose significant costs on the specialist. The specialist mitigates these costs through own-account trading when the rules are not binding. These findings bear on the current debate regarding market makers' behavior on the NYSE.

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