Maureen OHara Market Microstructure Theory

Chapter 2 Inventory Models

The equilibrium price is the price at which quantity demanded equals quantity supplied. But a closer examination of trading in securities markets raises questions as to how to apply this paradigm as well as to its value in predicting the fine behaviour of securities prices. For example, if buyers and sellers arrive at different points in time, to what time period do the supply and demand schedules refer? Similarly, if order to buy or sell are not always balanced in the selected time period, how does the price change to reflect the order flow? These issues were the focus of research by Garman (1976), that characterized an exchange market as a flow of orders to buy and sell, that would arise as the solution to the individual traders optimization problem. Orders would be submitted to the market and imbalances between supply and demand could temporally arise. This imbalance gave an importance to the temporal microstructure, or how the exchange between buyer and seller actually occurred at any point in time. Treating supply and demand as stochastic processes allowed the exchange process to be viewed from a different perspective; if the stochastic processes governing orders (i.e. the order arrival rates) were affected by the price prevailing in the market, then the optimal pricing mechanism must incorporate this relation. Moreover, since order imbalances were certain to occur, how the exchange mechanism operated would affect the provision of intertemporal liquidity. In Garmans model there is a single, monopolistic market maker who sets prices, receives all orders and clears trades. The dealers objective is to maximize expected profit per unit of time, subject to the avoidance of bankruptcy or failure. Failure arises in this model whenever the dealer runs our of either inventory or cash. The market makers only decision is to set an ask price, , at which he will fill orders wishing to buy stock, and a bid price, , at which he will fill orders wishing to sell the stock. The uncertainty in the model arises from the arrival of the buy and sell orders. With buy and sell orders following independent stochastic processes, the flow of buys and sells to the dealer will not be synchronous. It is this potential imbalance that is the crux of the dealers problem. Since the order arrival processes are stationary but not identical, balancing his level of inventory and cash to avoid running out of either is not a trivial problem for the market maker. The assumptions of the model require that the order flow be stochastic without being informative about future market or price movements. This is the general view taken in virtually all inventory-based microstructure models. In this framework, as in more standard ruin problems, the dealers failure probabilities are always positive. Consequently, no matter what price the dealer sets, there is no way to guarantee that he or she will not fail. To avoid certain failure a single market maker must set a lower price when he buys stock and a higher price when he sells. This results in a spread developing, and it implies that the spread is an inherent property of this exchange market structure. This spread protects the market maker from certain failure, but is not a panacea: he or she still faces a positive probability of failure. What determines the size and placement of this spread is

not immediately obvious. The dealer sets prices to equate the order arrival rates, pursuing a zero-drift inventory policy. However, there are multiple strategies that satisfy this condition; so where the dealer sets his prices depends on factors other than inventory. Given the dealers objective, the exact prices he sets are those which maximize the dealers expected profit. Setting different buying and selling prices allows the dealer to extract larger rents while still maintaining the zero-drift inventory requirement. As is typical for a monopolist, this pricing strategy results in volume at the optimal prices being less than would occur with competitive prices. Garmans analysis demonstrates that inventory determines the dealers viability; however, inventory per se plays no role in the dealers decision problem, since by assumption the dealer is allowed to set prices only at the beginning of trading. A more realistic approach to the underlying problem is to consider how the dealers prices change as his inventory position varies over time (Amihud and Mendelson, 1980). The dealers decision variables, his bid and ask prices, change over time depending on the level of the dealers inventory position. The optimal bid and ask prices are monotone decreasing functions of the dealers inventory position. As the dealers inventory increases, he lowers both bid and ask prices, and conversely he raises both prices as inventory falls. The model implies that the dealer has a preferred inventory position; as the dealer finds his inventory position departing from his preferred position, he moves his prices to bring his position back; once again, optimal bid and ask prices exhibit a positive spread. Whereas previously the spread arose partially because of the need to reduce failure probability, the spread here reflects the dealers efforts to maximize profits. Since the dealer is assumed to be risk neutral and a monopolist, the spread reflects the dealers market power. In this model, however, if the dealer faces competition, then the spread falls to zero; in this sense, the spread plays no role in the viability of the market but acts essentially as a transaction cost.