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Market making by an FX dealer: tiers, pricing ladders and hedging rates for optimal risk control

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  • Alexander Barzykin
  • Philippe Bergault
  • Olivier Gu'eant

Abstract

Dealers make money by providing liquidity to clients but face flow uncertainty and thus price risk. They can efficiently skew their prices and wait for clients to mitigate risk (internalization), or trade with other dealers in the open market to hedge their position and reduce their inventory (externalization). Of course, the better control associated with externalization comes with transaction costs and market impact. The internalization vs. externalization dilemma has been a topic of recent active discussion within the foreign exchange (FX) community. This paper offers an optimal control framework for market making tackling both pricing and hedging, thus answering a question well known to dealers: `to hedge, or not to hedge?'

Suggested Citation

  • Alexander Barzykin & Philippe Bergault & Olivier Gu'eant, 2021. "Market making by an FX dealer: tiers, pricing ladders and hedging rates for optimal risk control," Papers 2112.02269, arXiv.org, revised Jun 2023.
    • Handle: RePEc:arx:papers:2112.02269
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    References listed on IDEAS

    as
    1. Philippe Bergault & Olivier Guéant, 2021. "Size matters for OTC market makers: General results and dimensionality reduction techniques," Mathematical Finance, Wiley Blackwell, vol. 31(1), pages 279-322, January.
    2. Olivier Gu'eant & Charles-Albert Lehalle & Joaquin Fernandez Tapia, 2011. "Dealing with the Inventory Risk. A solution to the market making problem," Papers 1105.3115, arXiv.org, revised Aug 2012.
    3. Butz, M. & Oomen, R., 2019. "Internalisation by electronic FX spot dealers," LSE Research Online Documents on Economics 90485, London School of Economics and Political Science, LSE Library.
    4. Andreas Schrimpf & Vladyslav Sushko, 2019. "FX trade execution: complex and highly fragmented," BIS Quarterly Review, Bank for International Settlements, December.
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    8. Andreas Schrimpf & Vladyslav Sushko, 2019. "Sizing up global foreign exchange markets," BIS Quarterly Review, Bank for International Settlements, December.
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    10. Marco Avellaneda & Sasha Stoikov, 2008. "High-frequency trading in a limit order book," Quantitative Finance, Taylor & Francis Journals, vol. 8(3), pages 217-224.
    11. Alexander Barzykin & Philippe Bergault & Olivier Gu'eant, 2021. "Algorithmic market making in dealer markets with hedging and market impact," Papers 2106.06974, arXiv.org, revised Dec 2022.
    12. Olivier Gu'eant, 2016. "Optimal market making," Papers 1605.01862, arXiv.org, revised May 2017.
    Full references (including those not matched with items on IDEAS)

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