Dealing with the inventory risk: A solution to the market making problem

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 St 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 St 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. © 2012 Springer-Verlag.