Abstract
Market makers continuously set bid and ask quotes for the stocks they have under consideration. Hence they face a complex optimization problem in which their return, based on the bid-ask spread they quote and the frequency at which they indeed provide liquidity, is challenged by the price risk they bear due to their inventory. In this paper, we consider a stochastic control problem similar to the one introduced by Ho and Stoll (J Fin Econ 9(1): 47–73, 1981) and formalized mathematically by Avellaneda and Stoikov (Quant Fin 8(3):217–224, 2008). The market is modeled using a reference price S t following a Brownian motion with standard deviation σ, arrival rates of buy or sell liquidity-consuming orders depend on the distance to the reference price S t and a market maker maximizes the expected utility of its P&L over a finite time horizon. We show that the Hamilton–Jacobi–Bellman equations associated to the stochastic optimal control problem can be transformed into a system of linear ordinary differential equations and we solve the market making problem under inventory constraints. We also shed light on the asymptotic behavior of the optimal quotes and propose closed-form approximations based on a spectral characterization of the optimal quotes.
Similar content being viewed by others
References
Amihud Y., Mendelson H.: Dealership market. market-making with inventory. J. Fin. Econ. 8, 31–53 (1980)
Amihud Y., Mendelson H.: Asset pricing and the bid-ask spread. J. Fin. Econ. 17(2), 223–249 (1986)
Avellaneda M., Stoikov S.: High-frequency trading in a limit order book. Quant. Fin. 8(3), 217–224 (2008)
Bayraktar, E., Ludkovski, M.: Liquidation in limit order books with controlled intensity. Arxiv preprint arXiv:1105.0247 (2011)
Benston Robert L., George J.: Determinants of bid-asked spreads in the over-the-counter market. J. Fin. Econ. 1(4), 353–364 (1974)
Cartea, Á., Jaimungal S.: Modeling asset prices for algorithmic and high frequency trading. Working Paper (2010)
Cartea, Á., Jaimungal S.: Risk measures and fine tuning of high frequency trading strategies. Working Paper (2012)
Cartea, Á., Jaimungal, S., Ricci, J.: Buy low sell high: a high frequency trading perspective. Working Paper (2011)
Cohen K.J., Maier S.F., Schwartz R.A., Whitcomb D.K.: Market makers and the market spread: a review of recent literature. J. Fin. Quant. Anal. 14(04), 813–835 (1979)
Cohen K.J., Maier S.F., Schwartz R.A., Whitcomb D.K.: Transaction costs, order placement strategy, and existence of the bid-ask spread. J. Polit. Econ. 89(2), 287–305 (1981)
Garman M.B.: Market microstructure. J. Fin. Econ. 3(3), 257–275 (1976)
Guéant, O., Lehalle, C.A.: Existence and Uniqueness for the Avellaneda–Stoikov PDE. Working Paper. (2012)
Guéant, O., Lehalle, C.A., Fernandez-Tapia, J.: Optimal Execution with Limit Orders. Working Paper. SIAM J. Fin. Math. (2011) (to appear)
Guilbaud, F., Pham, H.: Optimal high frequency trading with limit and market orders. Quant. Fin. (2011) (to appear)
Guilbaud F., Pham H.: Optimal high frequency trading in a pro-rata microstructure with predictive information. Arxiv preprint arXiv:1205-3051 (2012)
Hendershott, T., Menkveld, A.: Price Pressures. Manuscript, VU University, Amsterdam (2009)
Ho, T.S.Y., Macris, R.G.: Dealer bid-ask quotes and transaction prices: An empirical study of some AMEX options. J. Fin. 39, 23–45 (1984)
Ho T., Stoll H.R.: Optimal dealer pricing under transactions and return uncertainty. J. Fin. Econ. 9(1), 47–73 (1981)
Ho T.S.Y., Stoll H.R.: The dynamics of dealer markets under competition. J. Fin. 38(4), 1053–1074 (1983)
Lehalle, C.A., Guéant, O., Razafinimanana, J. : High Frequency Simulations of an Order Book: a Two-Scales Approach. In: Abergel, F., Chakrabarti, B.K., Chakraborti, A., Mitra, M. (eds.) Econophysics of Order-Driven Markets, New Economic Windows, Springer, New York (2010)
Madhavan A., Smidt S.: An analysis of changes in specialist inventories and quotations. J. Fin. 48(5), 1595–1628 (1993)
Menkveld, A.J.: High Frequency Trading and The New-Market Makers. Social Science Research Network Working Paper Series (2010)
Mildenstein, E., Schleef, H.: The optimal pricing policy of a monopolistic marketmaker in the equity market. J. Fin. 38, 218–231, (1983)
O’Hara M., Oldfield G.S.: The microeconomics of market making. J. Fin. Quant. Anal. 21(04), 361–376 (1986)
Roll R.: A simple implicit measure of the effective bid-ask spread in an efficient market. J. Fin. 39(4), 1127–1139 (1984)
Author information
Authors and Affiliations
Corresponding author
Additional information
This research has been conducted within the Research Initiative “Microstructure des Marchés Financiers” under the aegis of the Europlace Institute of Finance.
Rights and permissions
About this article
Cite this article
Guéant, O., Lehalle, CA. & Fernandez-Tapia, J. Dealing with the inventory risk: a solution to the market making problem. Math Finan Econ 7, 477–507 (2013). https://doi.org/10.1007/s11579-012-0087-0
Received:
Accepted:
Published:
Issue Date:
DOI: https://doi.org/10.1007/s11579-012-0087-0