Dealer Inventory, Short Interest and Price Efficiency in the Corporate Bond Market
We propose an equilibrium model of over-the-counter corporate bond trading with short selling, asymmetric information and dealer inventory costs. The model predicts that higher inventory costs impose implicit short-sale constraints and are thus associated with lower price efficiency. We construct bond-level proxies for inventory costs and provide empirical evidence in support of the model's prediction. Our findings suggest that tighter post-GFC regulation may have had unintended consequences for corporate bond market quality.