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Traditional economic models of price-setting focus on call-auction markets in which all trading occurs simultaneously, at pre-established discrete times, with no market makers involved. Such models leave no role for any of the three sources of friction found in modern models of market liquidity: inventory, order-processing costs, and adverse selection. As market microstructure research has developed, researchers studying the links between market-maker inventories and liquidity have shed considerable light on how market makers (often modeled as dealers) resolve temporal imbalances in the continuous trading environment that characterizes most financial markets. In general, inventory models predict that market makers set ask prices above bid prices, that they lower their quotes when they have very large inventory positions, and that they may or may not change the magnitude of their quoted spreads as their inventory changes, depending on whether they are capital constrained or not. Models in which market makers face capital constraints also offer an explanation of flight to quality, in which the riskiest securities suffer the greatest liquidity declines. Multi-dealer inventory models predict that relative inventory positions give rise to interdealer trading and determine which dealers have the best (lowest ask or highest bid) quotes in a market. These predictions have been tested and largely borne out in empirical studies to date.


Required Publisher Statement
© Wiley. Final version published as: Moulton, P. C. (2010). Inventory effects. In R. Cont (Ed.), Encyclopedia of quantitative finance (Vol. 3, pp. 976-979). West Sussex, England: John Wiley & Sons, Ltd. Reprinted with permission. All rights reserved.