| Abstract: | We develop a dynamic model of market making incorporating inventory and information effects. The market maker is both a dealer and an investor, quoting prices that induce mean reversion in inventory toward targets determined by portfolio considerations. We test the model with inventory data from a New York Stock Exchange specialist. Specialist inventories exhibit slow mean reversion, with a half-life of over 49 days, suggesting weak inventory effects. However, after controlling for shifts in desired inventories, the half-life falls to 7.3 days. Further, quote revisions are negatively related to specialist trades and are positively related to the information conveyed by order imbalances. |
