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

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

Journal of Financial Markets, 2014, vol. 18, issue C, 25-48

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.

Keywords: Bid–ask spreads; Hedging costs; Inventory management; Liquidity; Option market making (search for similar items in EconPapers)
JEL-codes: D23 G12 G14 (search for similar items in EconPapers)
Date: 2014
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (15)

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Persistent link: https://EconPapers.repec.org/RePEc:eee:finmar:v:18:y:2014:i:c:p:25-48

DOI: 10.1016/j.finmar.2013.05.007

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