Do inventories matter in dealership markets? Evidence from the London Stock Exchange

Using London Stock Exchange data, we test the central implication of the canonical model of Ho and Stoll (1983) that relative inventory differences determine dealer behavior. We find that relative inventories explain which dealers obtain large trades and show that movements between best ask, best bid, and straddle are highly correlated with both standardized and relative inventory changes. We show that the mean reversion in inventories is highly nonlinear and increasing in inventory levels. We show that a key determinant of variations in interdealer trading is inventories and that interdealer trading plays an important role in managing large inventory positions.