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Intraday market making with overnight inventory costs

Tobias Adrian (), Agostino Capponi (), Erik Vogt and Hongzhong Zhang ()
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Agostino Capponi: Columbia University
Hongzhong Zhang: Columbia University

No 799, Staff Reports from Federal Reserve Bank of New York

Abstract: The share of market making conducted by high-frequency trading (HFT) firms has been rising steadily. A distinguishing feature of HFTs is that they trade intraday, ending the day flat. To shed light on the economics of HFTs, and in a departure from existing market-making theories, we model an HFT that has access to unlimited leverage intraday but must fund any end-of-day inventory at an exogenously determined cost. Even though the inventory costs occur only at the end of the day, they impact intraday price and liquidity dynamics. This gives rise to an intraday endogenous price impact mechanism. As the end of the trading day approaches, the sensitivity of prices to inventory levels intensifies, making price impact stronger and widening bid-ask spreads. Moreover, imbalances of buy and sell orders may catalyze hikes and drops in prices, even under fixed supply and demand functions. Empirically, we show that these predictions are borne out in the U.S. Treasury market, where bid-ask spreads and price impact tend to rise toward the end of the day. Furthermore, price movements are negatively correlated with changes in inventory levels as measured by the cumulative net trading volume. This paper is available from Columbia:

Keywords: market microstructure; market liquidity; high-frequency trading; financial intermediation (search for similar items in EconPapers)
JEL-codes: G01 G12 G17 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-mst
Date: 2016-10-21
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