HEC Research Papers Series,
HEC Paris

Abstract: We study the quoting activity of market makers in relation with trading, liquidity, and expected returns. Empirically, we find larger quote-to-trade (QT) ratios in small, illiquid or neglected firms, yet large QT ratios are associated with low expected returns. The last result is driven by quotes, not by trades. We propose a model of quoting activity consistent with these facts. In equilibrium, market makers monitor the market faster (and thus increase the QT ratio) in neglected, difficult-to-understand stocks. They also monitor faster when their clients are less risk averse, which reduces mispricing and lowers expected returns.

Keywords: Liquidity; price discovery; volatility; trading volume; monitoring; neglected stocks; risk aversion; inventory; high frequency trading

JEL-codes: G12; G14

50 pages, First version: July 1, 2017. Revised: January 26, 2018.

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