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Hedging costs, liquidity, and inventory management: The evidence from option market makers

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  • Wu, Wei-Shao
  • Liu, Yu-Jane
  • Lee, Yi-Tsung
  • Fok, Robert C.W.

Abstract

Hedging the risk of holding undesired inventory is very important for market makers. However, prior studies seldom capture the role of inventory positions in measuring hedging costs. This study measures hedging costs directly using data on inventory positions of market makers in the Taiwan Index Options market. We break down rebalancing costs into two sources: rebalancing costs due to inventory changes and rebalancing costs due to delta changes. Contrary to prior studies on stock options, we find rebalancing costs are more important than initial hedging costs in explaining option spreads. Our findings underscore the importance of inventory management.

Suggested Citation

  • 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.
  • Handle: RePEc:eee:finmar:v:18:y:2014:i:c:p:25-48
    DOI: 10.1016/j.finmar.2013.05.007
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    References listed on IDEAS

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    Cited by:

    1. Ersan, Oguz & Alıcı, Aslı, 2016. "An unbiased computation methodology for estimating the probability of informed trading (PIN)," Journal of International Financial Markets, Institutions and Money, Elsevier, vol. 43(C), pages 74-94.
    2. Chen, Chen & Lee, Hsiu-Chuan & Liao, Tzu-Hsiang, 2016. "Risk-neutral skewness and market returns: The role of institutional investor sentiment in the futures market," The North American Journal of Economics and Finance, Elsevier, vol. 35(C), pages 203-225.
    3. Huh, Sahn-Wook & Lin, Hao & Mello, Antonio S., 2015. "Options market makers׳ hedging and informed trading: Theory and evidence," Journal of Financial Markets, Elsevier, vol. 23(C), pages 26-58.
    4. Lin, William T. & Tsai, Shih-Chuan & Zheng, Zhenlong & Qiao, Shuai, 2017. "Does options trading convey information on futures prices?," The North American Journal of Economics and Finance, Elsevier, vol. 39(C), pages 182-196.

    More about this item

    Keywords

    Bid–ask spreads; Hedging costs; Inventory management; Liquidity; Option market making;

    JEL classification:

    • D23 - Microeconomics - - Production and Organizations - - - Organizational Behavior; Transaction Costs; Property Rights
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G14 - Financial Economics - - General Financial Markets - - - Information and Market Efficiency; Event Studies; Insider Trading

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