Inventory Constraints in Long-Only Bond Market Making
Summary
The discussion considers how a bond dealer who cannot sell short might adapt a market-making strategy designed for dealers with two-sided inventory flexibility. Its central argument is conditional: if a long-only dealer already holds enough inventory to support both sides of quoting, the dealer can act like a conventional market maker. If inventory is insufficient, the dealer has fewer feasible actions and is described as operating at a disadvantage relative to the assumed optimal two-sided strategy.
The answer conjectures that accumulating inventory to enable two-way quotes could form part of the dealer's strategy, constrained by a value-at-risk limit that keeps holdings as small as feasible. It does not develop a formal model, specify how to price quotes or measure the odd-lot liquidity premium, or provide evidence that the proposed inventory policy is optimal. The original question's odd-lot component therefore remains unanswered, and the argument relies on the assumption that a unique optimal unconstrained model exists.
Key ideas
- Sufficient bond inventory can let a long-only dealer support two-sided quoting.
- Limited inventory restricts the dealer's feasible market-making actions.
- Inventory accumulation may enable two-way quotes, subject to a risk limit.
- The answer offers a conjecture and does not model odd-lot liquidity premiums.
Tags
Full text
# Market Making in Long Only Dealer Markets/Odd Lots # Market Making in Long Only Dealer Markets/Odd Lots How do you adjust market making models from the equity space to the dealer space. For example, a bond dealer that cannot go short to make a market will naturally have a different quoting mechanism than a two sided equity market maker. How do you model this? Similarly, how does one model odd lot liquidity premium? A security may have a quoted bid/ask on round lots, but there may be a premium on odd lots not observed ## Answer by Attack68 (score 1) https://quant.stackexchange.com/a/58488 Assume a market-making model exists for original dealers that can go long and short and that this model is unique and optimal measured over each mutually exclusive bond. Suppose, now, a new dealer may go long only, but has a long position sufficient in a bond that he can effectively deal long and short positions. This new dealer is isomorphically equivalent to the original dealers and therefore, by contradiction, any other strategy that he employs, not the same as theirs, cannot be optimal for the specific bond(s). Suppose, on the other hand, that the new dealer does not have a position large enough in any bond to be equivalent to the original dealers then his strategy must be adjusted and must be sub-optimal to the original dealers (since the original dealers have the flexibility to also perform this strategy but do not since their own are assumed to be optimal). I would postulate at this point that a strategy to build long positions to create equivalence with original dealers would form a part of the new dealers strategy, but this would be counteracted most likely with a VaR restriction, i.e. the long positions would be as small as possible to permit two-way quoting.
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This summary was written by Stratmill's research agent from the original; it is not a copy of the source.