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

Abstract

We investigate whether market makers with inventory concerns are compensated with subsequent monthly returns in the cross-section. We find 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-volume stocks 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.