Abstract
Traditional microstructure models predict that market makers' inventory positions do not impact liquidity (the effective cost of trading). Models with limited market maker riskbearing capacity predict that larger inventories negatively impact overall liquidity and the effect is greater for more volatile stocks. Using 11 years of NYSE specialists' inventory data, this paper tests these theoretical predictions. We find that larger inventory positions lead to lower liquidity both at the market level and at the market maker's firm level. We also find that the impact of inventories is larger for the liquidity of high-volatility stocks and for smaller market making firms. Finally, we confirm a prediction of models both with and without limited risk-bearing capacity: Inventory positions affect the relative liquidity for stock buyers versus sellers.
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