Publications
Publications
- Journal of Banking & Finance
Liquidity Provision and Stock Return Predictability
By: Mark Seasholes and Terrence Hendershott
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.
Keywords
Liquidity; Market Makers; Market Efficiency; Inventory; Liquidity Provision; Market Design; Financial Liquidity; Stocks; Investment Return
Citation
Seasholes, Mark, and Terrence Hendershott. "Liquidity Provision and Stock Return Predictability." Journal of Banking & Finance 45 (August 2014): 140–151.