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 …, we find rebalancing costs are more important than initial hedging costs in explaining option spreads. Our findings …

using transaction data. We propose a new market microstructure theory called a derivative hedge theory, in which option … validity of volume as a proxy for liquidity and supports my theory. Option market spreads are positively related to spreads in … underlying market, as measured by the liquidity of this underlying market. In a perfect hedge world, spreads arise from the …