|M.Sc Student||Ilan Geller|
|Subject||Hedged Inventory Risk in Market Making of Derivative|
|Department||Department of Industrial Engineering and Management||Supervisors||Dr. Perets Hovav|
|Dr. Zahavi Gal|
|Full Thesis text|
Market makers are characterized in the literature according to four different functions. As auctioneers, price stabilizers, information processors, and suppliers of immediacy (Stoll ). The market maker processes orders, establishes transaction prices, and consequently bear inventory risk. Namely, the market makers are subject to loses in case of dramatic price change while anticipating a buyers arrival. In derivatives markets, these price changes can be partly hedged using other related securities reducing the inventory risk. In this work we construct a trading strategy for hedging inventory risk. We take into account trading premium, bid-ask spread and risk neutral probability, and model imperfections. In addition, we empirically test our strategy for seven year historical performance of 10 selected options, and show how the market making payoff distribution changes with respect to the un-hedged strategy. Finally, we illustrate how the strategy reproduce bid-ask quotes that fit the quotes witnessed in the market data, postulating that market makers hold a major role in derivatives markets.