Testing for asymmetric information and inventory control effects in market maker behaviour on the London Stock Exchange

Abstract

This paper examines the empirical relationship between 20 minute trading volume and price quotes announced by market makers for a sample of liquid stocks on the London Stock Exchange, over a settlement period in 1990. We outline a simple model which highlights three key players in the market: market makers, informed traders and liquidity traders. We determine the optimal prices that a market maker will quote as a function of the expected fundamental price, the expected number of liquidity trades and the lagged level of inventories. We then go on to analyse the empirical implications of this model, estimate the model's parameters using data provided by the London Stock Exchange and test the restrictions implied by our theory. The analysis yields tests for the existence of asymmetric information, stock control and liquidity trade effects on price quote revisions. We find little evidence of asymmetric information for our sample, but strong inventory control effects.