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Inventory Hedging And Option Market Making

Author

Listed:
  • ANTOINE GIANNETTI

    (Florida Atlantic University, College of Business, Depertment of Finance, 777 Glades Road, Boca Raton, FL 33431, USA)

  • RUI ZHONG

    (University of Texas and Cheung Kong Graduate School of Business, USA)

  • LIXIN WU

    (Claremont Graduate School, USA)

Abstract

In this paper, we develop an inventory-based approach to analyze the option market making activity. Indeed, we formulate and analytically solve the price-setting problem of a monopolistic option market maker facing exogenous public supply and demand first on a single exercise price (the "single option economy") and next on multiple exercise prices (the "multi-options economy"). While in the "single option economy" the familiar result that market maker inventory and price level are inversely related holds, the same is not necessarily true in the "multi-options economy". Additionally, we examine under which theoretical condition hedging is totally effective (i.e., the variance of the market maker hedged position is zero). Last but not least, our model is fully consistent with actual option market making practices, which consist in trading hedge portfolios to reduce risk. As such, our approach can be considered as a bridge between market microstructure and standard option pricing literature.

Suggested Citation

  • Antoine Giannetti & Rui Zhong & Lixin Wu, 2004. "Inventory Hedging And Option Market Making," International Journal of Theoretical and Applied Finance (IJTAF), World Scientific Publishing Co. Pte. Ltd., vol. 7(07), pages 853-878.
    • Handle: RePEc:wsi:ijtafx:v:07:y:2004:i:07:n:s0219024904002670
    DOI: 10.1142/S0219024904002670
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    References listed on IDEAS

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    1. Madhavan, Ananth, 2000. "Market microstructure: A survey," Journal of Financial Markets, Elsevier, vol. 3(3), pages 205-258, August.
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    Cited by:

    1. Wu, Wei-Shao & Liu, Yu-Jane & Lee, Yi-Tsung & Fok, Robert C.W., 2014. "Hedging costs, liquidity, and inventory management: The evidence from option market makers," Journal of Financial Markets, Elsevier, vol. 18(C), pages 25-48.
    2. Naomi Boyd, 2015. "Market making and risk management in options markets," Review of Derivatives Research, Springer, vol. 18(1), pages 1-27, April.

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    Keywords

    Option market making; inventory model;

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