ADVERSE SELECTION,INVENTORY‐HOLDING COSTS,AND DEPTH

We examine whether specialist depth quotes are related to the adverse‐selection and inventory‐holding‐cost components of the spread. Consistent with theory that predicts an inverse relation between depths and informed trading risk, we find that depth quotes are strongly inversely related to the adverse‐selection component of the spread. We also find that depth quotes are inversely related to the inventory‐holding‐cost component, though this relation is weaker than the relation between depths and adverse selection. Our evidence suggests cross‐sectional variation in depths is driven primarily by variation in informed trading risk, as proxied for by the adverse‐selection component, rather than by inventory concerns. JEL classification: G10, G14