Liquidity provision and stock return predictability

Terrence Hendershott, Mark Seasholes

Research output: Contribution to journalArticle

4 Citations (Scopus)

Abstract

This paper examines the trading behavior of two groups of liquidity providers (specialists and competing market makers) using a six-year panel of NYSE data. Trades of each group are negatively correlated with contemporaneous price changes. To test for return predictability, we sort stocks into quintiles based on each group's past trades and then form long-short portfolios. Stocks most heavily bought have significantly higher returns than stocks most heavily sold over the two weeks following a sort. Cross-sectional analysis shows smaller, more volatile, less actively traded, and less liquid stocks more often appear in the extreme quintiles. Time series analysis shows the long-short portfolio returns are positively correlated with a market-wide measure of liquidity. A double sort using past trades of specialists and competing market makers produces a long-short portfolio that earns 88 basis points per week (act as complements). Finally, we identify a "chain" of liquidity provision. Designated market makers (NYSE specialists) initially trade against order flows and prices changes. Specialists later mean revert their inventories by trading with competing market makers who appear to spread trades over a number of days. Alternatively, specialists may trade with competing market makers who arrive to market with delay.

Original languageEnglish (US)
Pages (from-to)140-151
Number of pages12
JournalJournal of Banking and Finance
Volume45
Issue number1
DOIs
StatePublished - 2014
Externally publishedYes

Fingerprint

Market makers
Liquidity provision
Stock return predictability
Liquidity
Price changes
New York Stock Exchange
Return predictability
Cross-sectional analysis
Stock returns
Time series analysis
Order flow
Trading behavior

Keywords

  • Inventory
  • Liquidity
  • Liquidity provision
  • Market efficiency
  • Market makers

ASJC Scopus subject areas

  • Finance
  • Economics and Econometrics

Cite this

Liquidity provision and stock return predictability. / Hendershott, Terrence; Seasholes, Mark.

In: Journal of Banking and Finance, Vol. 45, No. 1, 2014, p. 140-151.

Research output: Contribution to journalArticle

Hendershott, Terrence ; Seasholes, Mark. / Liquidity provision and stock return predictability. In: Journal of Banking and Finance. 2014 ; Vol. 45, No. 1. pp. 140-151.
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