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

Author

Listed:
  • Alexander Barzykin

    (HSBC)

  • Philippe Bergault

    (CMAP - Centre de Mathématiques Appliquées - Ecole Polytechnique - X - École polytechnique - CNRS - Centre National de la Recherche Scientifique)

  • Olivier Guéant

    (UP1 - Université Paris 1 Panthéon-Sorbonne, CES - Centre d'économie de la Sorbonne - UP1 - Université Paris 1 Panthéon-Sorbonne - CNRS - Centre National de la Recherche Scientifique)

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 Guéant, 2022. "Market making by an FX dealer: tiers, pricing ladders and hedging rates for optimal risk control," Université Paris1 Panthéon-Sorbonne (Post-Print and Working Papers) hal-03857971, HAL.
    • Handle: RePEc:hal:cesptp:hal-03857971
    as

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