Optimal Market-Making with Risk Aversion

Kan Huang (), David Simchi-Levi () and Miao Song ()
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Kan Huang: Sloan School of Management, Massachusetts Institute of Technology, Cambridge, Massachusetts 02139
David Simchi-Levi: Department of Civil and Environmental Engineering, the Engineering Systems Division and the Operations Research Center, Massachusetts Institute of Technology, Cambridge, Massachusetts 02139
Miao Song: Department of Industrial and Manufacturing Systems Engineering, University of Hong Kong, Hong Kong

Operations Research, 2012, vol. 60, issue 3, 541-565

Abstract: Market-makers have the obligation to trade any given amount of assets at quoted bid or ask prices, and their inventories are exposed to the potential loss when the market price moves in an undesirable direction. One approach to reduce the risk brought by price uncertainty is to adjust the inventory at the price of losing potential spread gain. Using stochastic dynamic programming, we show that a threshold inventory control policy is optimal with respect to an exponential utility criterion and a mean-variance trade-off model. Symmetric and monotone properties of the threshold levels are also established.

Keywords: market-making; inventory control; risk aversion; dynamic programming; optimal policy (search for similar items in EconPapers)
Date: 2012
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Citations: View citations in EconPapers (7)

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