Order Flows and Stock Returns: Compensation for Market Makers with Inventory Concerns

Published date01 August 2014
Date01 August 2014
The Financial Review 49 (2014) 511–538
Order Flows and Stock Returns:
Compensation for Market Makers
with Inventory Concerns
Moonsoo Kang
Iona College
Bong-Soo Lee
Florida State University
We investigate whether market makers with inventory concerns are compensated with
subsequent monthly returns in the cross-section. Wefind a significant negative relation between
order flows and monthly returns, “the order flow effect,” suggesting that market makers lower
prices for stocks with sell order flows and demand a reward in the form of higher expected
returns. Further, the order flow effect is stronger for high-volatility or high-volumestocks for
which market makers have serious inventory concerns. Funding liquidity of market makers
also affects the order flow effect. Finally, our finding is independent of existing regularities
and robust to the decimalization.
Keywords: order flows, stock returns, market maker, inventory concerns
JEL Classifications: G10, G14
Corresponding author: Hagan School of Business, Iona College, 715 North Avenue,New Rochelle, NY
10801; Phone: (914) 633-2530; Fax: (914) 633-2286; E-mail: mkang@Iona.edu.
We would like to thank Robert Van Ness (the editor) and two anonymous referees for constructive and
detailed suggestions. Helpful comments were received from the seminar participants at 2012 Eastern
Finance Association meeting and 2012 Financial Management Association meeting. The usual disclaimer
C2014 The Eastern Finance Association 511
512 M. Kang and B.-S. Lee/The Financial Review 49 (2014) 511–538
1. Introduction
The finance literature suggests two perspectives on the order flow-return reg-
ularity. First, the behavioral finance literature argues that unsophisticated retail
traders drive both short- and long-term relations between order flows and returns
(Hvidkjaer, 2008; Barber, Odean and Zhu, 2009). On the other hand, the mar-
ket microstructure literature attributes the short-term positive relation to sophisti-
cated market makers who accommodate auto-correlated order flows (Chordia and
Subrahmanyam, 2004). Therefore, unlike a short-term order flow-return pattern, a
long-term negative relation seems consistent mainly with the behavioral financeliter-
ature. However, we arguethat the long-term pattern can also be explained within the
rational market maker framework.1Accordingto Grossman and Miller (1988), market
makers charge for bearing price risk associated with incoming order flows by offer-
ing a lower price, on average. Eventually, the stock price rises and the price reversal
becomes the market makers’ return for providing liquidity. Our study complements
the recent literature on the order flow-return relation by empirically investigating
the role of rational market makers in affecting the cross-sectional order flow-return
pattern over longer, specifically monthly, horizons.
Empirically, only a few papers study liquidity provision in the order flow-
return pattern over longer horizons. Hendershott and Seasholes (2007) show that
NYSE specialist inventories are positively correlated with subsequent daily or weekly
returns, suggesting that market makers accommodate buying and selling pressure
because they are compensated by favorable subsequent price movements. Recently,
Subrahmanyam (2008) analyzes the cross-sectional relation between lagged monthly
order flows and returns. However, he reports that only negative lagged order flows
affect returns over a two-month horizon. On the other hand, Kaniel, Saar and Titman
(2008) find that individual investor-driven order flows show a positive relation with
subsequent monthly returns, suggesting that individual investorsare compensated for
providing liquidity for institutional investors demanding immediacy.2
In our analysis, we show that sell order-driven stocks indeed outperform buy
order-driven stocks in the following months based on the cross-sectional Fama-
Macbeth (1973) monthly regression. We call this finding “the order flow effect.” By
forming portfolios based on order flows and rebalancing them every month, we also
find that the order flow-return relation lasts over a long period and that its pattern
is influenced by some factors. Specifically, the order flow effect is observed up to
12 months after the order flow formation, especially for stocks with high volatility
or high trade volume. For further investigation, we examine the performance of a
1For the market microstructure literature on the maker maker’s inventory risk, see Ho and Stoll (1983)
and Spiegel and Subrahmanyam (1995). For a more general discussion on the role of market makers, see
Grossman and Miller (1988).
2Brennan, Chordia, Subrahmanyam and Tong (2012) show empirical evidencefor the permanent infor-
mation effect based on the sell-side price impact using the Kyle (1985) lambda.

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