Option Market Making with Inventory Risk: The Effect on Information Diffusion
42 Pages Posted: 8 Jul 2020
Date Written: June 15, 2020
This paper develops a model to study how option market makers' inventory and capital influence the relative informativeness of the option and stock markets. The model suggests that the option market maker's capital defines a lower bound for the option market informativeness. In addition, when perfect hedging is impossible, a larger inventory of sold (bought) options diminishes the informativeness of changes in the option's ask (bid) quote and increases the informativeness of changes in the option's bid (ask) quote. Finally, the model implies that noisy information is more likely to enter through the option market than the stock market. My empirical analysis provides stylized facts consistent with the model's key implications.
Keywords: market micro-structure, inventory, asymmetric information, hedging, options
JEL Classification: G11, G14, G23, G41
Suggested Citation: Suggested Citation