Mathematical Finance Seminar: "Intraday Market Making with Overnight Inventory Costs"

Abstract: The Treasury market is highly intermediated by non-bank proprietary trading firms. Their small balance sheets enforce the need of ending the day flat to limit margins requirements for holding overnight positions. To shed light on the impact these new intermediaries have on market quality, we develop a continuous time market making model in which the profit maximizing firm faces overnight inventory costs. We develop closed-form representations of the optimal price policy functions, highlighting a negative relation between changes in prices and in inventory holdings. Our model reveals that bid-ask spreads widen with time, and that increases in order arrival rates do not always lead to higher price volatility. We provide empirical evidence for our predictions, and show that the model reproduces the temporal pattern empirically observed in U.S. Treasury data. This is joint work with Tobias Adrian, Erik Vogt, and Hongzhong Zhang.

Host: Jose Figueroa-Lopez