Dealer Inventory Behavior: An Empirical Investigation of NASDAQ Stocks

1. This paper presents and tests a model of dealer inventory response. The estimated inventory responsiveness coefficient is statistically significant and its magnitude is consistent with reasonable values of underlying variables which, it is hypothesized, determine the coefficient.2. The sign of the inventory responsiveness coefficient indicates that dealers tend to be passive and acquire shares when prices fall and sell shares when prices rise. This type of behavior is sometimes termed “stabilizing.”3. Dealer inventories tend to increase on days prior to price declines and tend to decrease on days prior to price increases; that is, inventory changes tend to be “destabilizing” with respect to future price changes. This implies that a fraction of the public trades on superior information and that dealers tend to lose money to such information traders.4. There is a strong tendency for dealer inventory levels to return to normal, presumably zero. The implied typical inventory holding period is about 8 to 10 trading days.5. Comparison of NASDAQ dealers and NYSE specialists shows that the pattern of inventory responsiveness is very much the same for the two. This suggests that both act in accordance with the underlying economic model and that differential regulation has little effect on typical inventory responsiveness.6. This finding does not obviate the possibility that individual dealers or specialists behave in atypical or undersirable ways, and that the extent of such atypical behavior might depend on the degree of public regulation of dealer activities. An exhaustive comparative study of deviations from normal behavior was not possible. However, it was possible to compare the frequency of nonstabilizing transactions in which price change and inventory change on a given day are in the same, rather than opposite, direction. One could not conclude that NASDAQ dealers had more nonstabilizing activity than NYSE specialists.