Hedging costs, liquidity, and inventory management: The evidence from option market makers

Hedging the risk of holding undesired inventory is very important for market makers. However, prior studies seldom capture the role of inventory positions in measuring hedging costs. This study measures hedging costs directly using data on inventory positions of market makers in the Taiwan Index Options market. We break down rebalancing costs into two sources: rebalancing costs due to inventory changes and rebalancing costs due to delta changes. Contrary to prior studies on stock options, we find rebalancing costs are more important than initial hedging costs in explaining option spreads. Our findings underscore the importance of inventory management.