Inventory management effects, isolated: Evidence from the federal funds market

The federal funds market is highly competitive, has uniform information, and does not have most order-processing cost components of equity markets. Hence, it provides an opportunity to study the effect of inventory management on the bid-ask spread in an isolated fashion. Using a unique data set of daily borrowing and lending federal funds quotes posted by a large commercial bank, we find that the bank maintains a fairly constant bid-ask spread throughout a two-week reserve maintenance period. It acts similarly to a market maker facilitating flow of funds between depository institutions throughout the reserve maintenance period. The bank becomes more active toward the end of the period. In particular, on settlement Wednesday it increases the bid and ask quotes relative to the effective federal funds rate in an apparent attempt to manage its reserve inventory and satisfy its own reserve requirements.