Inventory Risk with Persistent Liquidity Shocks

One of the main sources of illiquidity in financial markets is that risk-averse intermediaries need to be compensated for the risk they are taking on their inventory positions. The paper develops a tractable dynamic model of inventory risk with a simple closed form solution for the optimal behavior of intermediaries. The model is then applied to the case, in which the order flow is positively auto-correlated, which is a commonly observed feature of many markets. In such case the quotes set by intermediaries will depend not only on their inventory positions, but also on the recent history of trades. One implications is that the usual methods of estimating the size of the inventory risk component generate biased results. The estimation of the model on microstructure data from equity markets shows that the positive auto-correlation in the order flow is significant and considerably affects the estimates of the inventory risk component.