This paper examines the empirical relationship between half-hourly trading volume and price quotes announced by market makers for a sample of liquid stocks on the London Stock Exchange, over a two week settlement period in 1990. We outline a model which highlights three key players in the market: market makers, informed traders and liquidity traders. We determine the optimal prices that a market maker will quote as a function of the expected fundamental price, the expected number of liquidity trades and the lagged level if inventories. We then go on to analyse the empirical implications of this model, estimate the model's parameters using data provided by the London Stock Exchange and test the restrictions implied by our theory. The analysis yields tests tests for the existence of asymmetric information, stock control and liquidity trade effects on price quote revisions.
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