Option Market Making under Inventory Risk

Sasha Stoikov

Mehmet Saglam
March 4, 2008
Abstract
We propose a mean-variance framework to analyze the optimal quoting
policy of an option market maker. The market makers mean prots come
from transaction premiums received over the course of a trading day, while
the variance comes from uncertainty in the value of the inventory. In order to
dierentiate the rst order risks from higher order ones, we present two models
consistent with our framework. The rst one focuses on Delta risk, arising from
changes in the underlying stock price, by modeling a market maker in the stock
and the option. We nd that, since the stock is more liquid than the option,
the market maker moves the stock quotes more aggressively than the option
quotes to hedge the net Delta of the inventory. The second model focuses on
Vega and Gamma risks, arising from stochastic volatility and discrete hedging,
by modeling a market maker in the option, who can costlessly delta-hedge with
the stock. In this setting, the market maker moves the option quotes by an
amount proportional to the net Vega and Gamma of the inventory.
1 Introduction
We study the optimal bid and ask prices at which an options dealer, or market
maker, sets his quotes. An options dealer is a market participant who dynami-
cally updates bid and ask quotes and waits for orders to arrive. More precisely,
we wish to understand how far the bid and ask quotes should be from the
markets mid price, dened to be the average of the best bid and ask quotes
available in the market. This quoting policy depends on the risk of the dealers
inventory position as well as the liquidity of the market, modeled by the arrival
intensity of orders as a function of how far the quotes are from the mid price.
From an empirical perspective, we are inspired by papers describing the
behavior of option dealers. For instance, in Garleanu et al (2006), the authors

Stoikov acknowledges support from the Morgan Stanley Equity Market Microstructure Research
Grant program. The views expressed herein are solely those of the authors and not those of Morgan
Stanley.
1
nd that the net demand for options exerts pressure on option prices, when
perfect replication is impossible. They derive the sensitivity of option prices
with respect to net demand and they nd that it depends on the standard
Greeks, Gamma and Vega. The price eect of risk due to discrete time
hedging is dependent on the options Gamma, while the price eect of risk
due to stochastic volatility depends on Vega. A related insight may be found
in Jameson and Wilhelm (1992), who show that Gamma and Vega contribute
signicantly to the bid-ask spread.
From a theoretical perspective, our stochastic control problem can be viewed
as an inventory management problem, where the order ow depends on the bid
and ask prices. This type of problem was rst studied by Ho and Stoll (1981)
and an empirical analysis was applied to the options market by Ho and Macris
(1984). These authors show that if a dealers goal is to maximize expected
utility, he will adjust his quotes in response to inventory positions. As one
would expect, when the dealers inventory is positive, the quotes should be
lowered and when the inventory is negative, the quotes should be raised. This
simple risk-management mechanism helps the dealer keep inventory positions
under control.
There are some important dierences between our model and the one de-
scribed above. First, we consider a dealer in both the stock and the option
market. This approach allows us to model the relative liquidity of the option
and stock markets and to study how a dealer may transfer liquidity across them.
Second, rather than using a utility function, we choose a mean-variance ob-
jective. This type of objective has enjoyed a revival in the optimal order execu-
tion literature (see Almgren and Chriss (2001), Engle and Ferstenberg (2006))
and is a natural choice to address optimal market making strategies. Indeed,
we nd that a fast numerical procedure can be implemented to determine the
optimal bid and ask prices, without resorting to asymptotic expansions, as is
often the case in stochastic control problems of this nature.
Third, we choose an investment horizon of one day, and explicitly separate
the problem into a day of trading, followed by an overnight move in the stock
and option prices. The advantage of our approach is that we can capture the
often observed fact that dealers tend to go home at (see Hasbrouck (2007)).
Indeed, by framing our problem in a twenty four hour horizon, we nd that the
optimal dealer will move his quotes so as to avoid keeping excessive inventory
overnight.
In Section 2, we present the model: the dynamics of the mid prices, the
evolution of the dealers wealth, the order ow and the dealers objective. In
Section 3, Delta Risk, we focus on the role of the net Delta on the dealers bid
and ask quotes. We solve a version of the model where the option and the stock
are related through the Black-Scholes formula, rst in a one-period setting, then
in a multi-period setting where all the price moves occur overnight, and nally
in a multi-period setting where prices evolve continuously. We illustrate the
fact that our mean-variance problem allows us to trace out the ecient frontier
for a dealer, in analogy with the classic Markowitz framework. In Section
2
4, Gamma and Vega Risk, we introduce a version of the model where the
option inventory is delta-hedged over the course of the trading day, but where
the dealer is subject to residual risks due to stochastic volatility and overnight
moves in the stock price. Once again, we present the one-period and the multi-
period versions of the model. We nd that the bid and ask quoting policy
depends on the net Gamma and Vega of the dealer. This aects long and short
maturity options dierently and we illustrate this by numerically computing
the dealers optimal policies. We present our conclusions in Section 5, and the
proofs are all included in the appendix.
2 The model
The time horizon. We divide the trading day into n sessions 0 = t
0
< t
1
<
... < t
n
. At the beginning of every session, the dealer sets bid and ask quotes on
the stock (p
b,s
i
and p
a,s
i
) and on the option (p
b,o
i
and p
a,o
i
) for 0 i n1, and
waits for market orders to arrive. At the end of the nth session, the market is
closed, no trading occurs in the interval (t
n
, T] and there is an overnight move in
the asset prices, where T represents the beginning of the following trading day.
The explicit modeling of this overnight move is an important ingredient of our
modeling. Because the dealer is unable to trade in the interval (t
n
, T], the bid
and ask quotes will turn out to be more sensitive to the inventory positions as
the end of the day approaches. This feature diers from the inventory models
of Ho and Stoll (1981), where the sensitivity of the quotes with respect to
inventory decreases as the horizon T approaches.
The market dynamics. We now describe the dynamics of the stock mid
price. We choose to model the stock price as a martingale under the historic
measure, to reect the idea that the dealer has no information on the future
direction of the stock price. In other words, the dealer considers the market
price to be the true value of the stock at all times. Consequently, the dealer
will attempt to keep an inventory in stocks and options that uctuates around
zero.
If we assume that the interest rate r = 0, the stock and option price dynam-
ics must also be martingales under the risk neutral measure to avoid arbitrage
opportunities. Eectively, we choose a model where the dynamics under the
historic and risk-neutral probability measures coincide in order to focus on the
eects of a stochastic inventory on the dealers quotes.
The continuous time dynamics of the stock mid price is given by
dS
t
= S
t
dW
t
The dealer makes markets in a European call option with maturity T
mat
>>
T and strike K, whose mid price follows
dC
t
=
t
dt +
t
dS
t
+
1
2

t
(dS
t
)
2
3
where the function C(S, t) is given by the Black Scholes formula and
t
,
t
and
t
are the standard greeks, Theta, Delta and Gamma, respectively. Using
the Black Scholes PDE, we obtain the following approximation
C
i
=
i
S
i
u

t
where u is a standard normal random variable and the time step t may rep-
resent one of the trading sessions or an overnight move.
The dealers state variables and controls. The wealth Y
i
of the market
maker is
Y
i
= X
i
+q
s
i
S
i
+q
o
i
C
i
where X
i
is the dollar amount of cash and q
s
i
and q
o
i
are the number of stocks
and options in inventory. We assume without loss of generality that X
0
= 0,
q
s
0
= 0, q
o
0
= 0 and therefore the initial wealth Y
0
is also zero. The change in
Y
i
over period (t
i
, t
i+1
) will depend on (i) the arrival of a new stock or option
transaction and (ii) returns on the stocks and options held in inventory. We
therefore decompose the change in wealth into two components
Y
i
= Y
i+1
Y
i
= Z
i
+ I
i
where
Z
i
X
i
+ q
s
i
S
i
+ q
o
i
C
i
is the change in wealth due to transactions and
I
i
q
s
i+1
S
i
+q
o
i+1
C
i
(2.1)
is the change in the market value of the inventory. Note that since no trading
occurs in the period (t
n
, T),
Z
n
Z
T
Z
n
= 0
and
I
n
I
T
I
n
= q
s
n
(S
T
S
n
) +q
o
n
(C
T
C
n
). (2.2)
Rather than crossing the spread, or even worse, impacting the price adversely
by trading with market orders, the dealer will deal exclusively with limit orders.
In other words, the dealer quotes bid and ask prices around the stocks mid
price,
p
b,s
i
= S
i

b
i
p
a,s
i
= S
i
+
a
i
around the options mid price,
p
b,o
i
= C
i

b
i
p
a,o
i
= C
i
+
a
i
4
and stands ready to trade one unit of stock or option at the prices above.
If we only admit controls
a
i
,
b
i
,
a
i
and
b
i
that are greater than zero, these
prices represent an improvement over the mid price. As long as the mid price
specications are arbitrage free, the dealers quotes cannot be arbitraged.
The liquidity. The bid and ask quotes, or equivalently the premiums
a
i
,
b
i
,

a
i
and
b
i
, indirectly inuence the inventory held by the market maker, since
they aect the arrival rates of orders. In the sequel, we let

s
() =
_
AB if 0 < A/B
0 if A/B
(2.3)
and

o
() =
_
C D if 0 < C/D
0 if C/D
(2.4)
be the Poisson arrival rates of stock and option orders, respectively. This choice
of piecewise linear functions simply reects the fact that the closer the quotes
are to the mid price, the higher the intensity of arrival of orders. The constants
A, B, C and D will allow us to capture the relative liquidity of the stock and
option markets.
Assuming that the trading sessions t are small enough for only one event
(purchase or sale of a stock or option) to occur, the probabilities associated
with transactions returns and changes in inventory are given by
P(Z
i
= 0) = P(q
s
i
= 0, q
o
i
= 0) = 1
_

s
(
b
i
) +
s
(
a
i
) +
o
(
b
i
) +
o
(
a
i
)
_
t
P(Z
i
=
b
i
) = P(q
s
i
= 1, q
o
i
= 0) =
s
(
b
i
)t
P(Z
i
=
a
i
) = P(q
s
i
= 1, q
o
i
= 0) =
s
(
a
i
)t
P(Z
i
=
b
i
) = P(q
s
i
= 0, q
o
i
= 1) =
o
(
b
i
)t
P(Z
i
=
a
i
) = P(q
s
i
= 0, q
o
i
= 1) =
o
(
a
i
)t
(2.5)
The objective. We consider the stochastic control problem of a dealer who
sets bid and ask prices throughout the trading day. The value function is
v(X
0
, S
0
, q
s
0
, q
o
0
, t
0
) = max

a
i
,
b
i
,
a
i
,
b
i
,0in1
_
E[Z
T
]
n

i=0
V ar[I
i
]
_
(2.6)
The dealer wishes to maximize prot from transactions, with a penalty pro-
portional to the variance of inventory value. Notice that the variance penalty
aects changes in the inventory value over each trading session, as well as the
overnight variance. This forces the dealer to keep the inventory under control.
3 Delta risk
In this section, we solve problem (2.6), rst in a one-period model (Section
3.1), then in a multi-period model where all the price moves occur overnight
5
(Section 3.2), and nally in a multi-period model where prices evolve continu-
ously (Section 3.3). Since the stock and option prices are related through the
Black-Scholes formula, there is essentially only one source of risk, captured by
the net Delta of the dealers position (q
s
+ q
o
). This net Delta aects the
optimal premiums
a
i
,
b
i
,
a
i
and
b
i
that the dealer charges around the mid
prices.
3.1 One-period model
Let us rst solve the one-period version of our model. To keep notation coherent
with the rest of the paper, we consider the dealers problem at the beginning
of the last trading session, assuming that he may only trade in the interval
(t
n1
, t
n
). The dealer chooses bid and ask quotes at time t
n1
, dened through
the controls
a
n1
,
b
n1
,
a
n1
and
b
n1
. These quotes inuence the probabilities
of the four possible transactions (see (2.5)) over the time interval (t
n1
, t
n
).
The stock and option then move, without the possibility of any further trading
until time T.
The dealers objective is to maximize expected marked to market wealth at
time T, with a penalty term that is proportional to the variance of the change in
value of the inventory. This mean-variance objective therefore strikes a balance
between the desire to maximize the marked to market prots made from the
bid ask spread and the risk associated with changes in market prices.
The value function can be written as
v(X
n1
, S
n1
, q
s
n1
, q
o
n1
, t
n1
) = max

a
n1
,
b
n1
,
a
n1
,
b
n1
(E[Z
T
] V ar[I
T
I
n1
]) .
(3.1)
The dealers objective is to determine the optimal bid and ask quotes on the
stock and options market.
Theorem 3.1. The optimal policy for the dealer is given by

a
n1
= max
_
0, min
_
A
B
,
A
2B

2
(T t
n1
)S
2
n1
_
q
s
n1
+q
o
n1

n1

1
2
___

b
n1
= max
_
0, min
_
A
B
,
A
2B
+
2
(T t
n1
)S
2
n1
_
q
s
n1
+q
o
n1

n1
+
1
2
___

a
n1
= max
_
0, min
_
C
D
,
C
2D

2
(T t
n1
)S
2
n1

n1
_
q
s
n1
+q
o
n1

n1

1
2

n1
___

a
n1
= max
_
0, min
_
C
D
,
C
2D
+
2
(T t
n1
)S
2
n1

n1
_
q
s
n1
+q
o
n1

n1
+
1
2

n1
___
(3.2)
Remark 3.1. In the risk neutral case where = 0, the objective is to maximize
terminal wealth and the optimal premiums are
=
A
2B
and
=
C
2D
6
regardless of inventory.
Remark 3.2. Notice that if the dealer is risk-averse, i.e. > 0, he adjusts or
tilts all his quotes away from the prot maximizing solution by an amount
proportional to
q
s
n1
+q
o
n1

n1
which is the net Delta. Also note that the solution (3.2) is less sensitive to
inventory as one approaches the horizon T.
3.2 Multi-period model, no intraday movement
We now consider a multi-period model where the stock price does not move
during the day and the only inventory risk comes from the possibility of an
overnight move. This simplies the problem, since most of the variance terms
in (2.6) drop out and the only source of uncertainty during the trading day
comes from the transactions. In this setting the stock and option premiums
a
,

b
,
a
and
b
can be computed recursively as functions of time and inventory
(see Theorem 3.2).
The stock price is xed at S
i
= S for i n and
S
T
= S +S(W
T
W
tn
).
Likewise, the option price remains constant at C
i
= C throughout the day and
then becomes
C
T
= C +S
n
(W
T
W
tn
).
The objective (2.6) simplies to:
v
0
(X
0
, S
0
, q
s
0
, q
o
0
, t
0
) = max

a
i
,
b
i
,
a
i
,
b
i
,0in1
(E[Z
T
] V ar[I
n
])
If we dene
v
j
(Z
j
, q
s
j
, q
o
j
) = max

a
i
,
b
i
,
a
i
,
b
i
,jin1
_
E[Z
T
|F
j
] V ar[I
n
|F
j
]
_
we may use the dynamic programming principle
v
j
(Z
i
, q
s
i
, q
o
i
) = max

a
i
,
b
i
,
a
i
,
b
i
E[v
i+1
(Z
i+1
, q
s
i+1
, q
o
i+1
)|F
i
]
to nd the optimal bid and ask quotes by working backward in a tree.
The computational task of building a non-recombining 5-nomial tree to
solve such a problem seems daunting. Fortunately, the value function v
i
can
be expressed as the linear combination of (i) the marked to market wealth Z
i
accumulated until time i and (ii) a piecewise quadratic function of inventory. It
follows that the optimal bid and ask premiums are piecewise linear in inventory.
This is summarized in the following theorem.
7
Theorem 3.2. The value function at time t
i
is given by
v
i
(Z
i
, q
s
i
, q
o
i
) = Z
i
+w
i
(q
s
i
, q
o
i
)
where w
i
is a quadratic function of inventory
w
i
(q
s
i
, q
o
i
) = m
i
_
q
s
i
+
n
q
o
i
_
2
+f
i
where m
i
and f
i
are given recursively by
m
i
= m
i+1
+ t
_
Bx +D
2
n
y
_
m
2
i+1
f
i
= f
i+1
+ t
_
_
A
2
4B
+
1
4
Bm
2
i+1
+
1
2
Am
i+1
_
x +
_
C
2
4D
+
1
4
Dm
2
i+1

4
n
+
1
2
Cm
i+1

2
n
_
y
Am
i+1
_
11
{
a
i
=0}
+ 11
{
b
i
=0}
_
Cm
i+1

2
n
_
11
{
a
i
=0}
+ 11
{
b
i
=0}
__
where x =
_
11
{0<
a
i
<
A
B
}
+ 11
{0<
b
i
<
A
B
}
_
and y =
_
11
{0<
b
i
<
C
D
}
+ 11
{0<
b
i
<
C
D
}
_
and
terminal conditions are
m
n
=
2
S
2
(T t
n
)
f
n
= 0.
Moreover, the optimal bid and ask premiums at time t
i
are given by

a
i
= max
_
0, min
_
A
B
,
A
2B
+m
i+1
_
q
s
i
+
n
q
o
i

1
2
_
__

b
i
= max
_
0, min
_
A
B
,
A
2B
m
i+1
_
q
s
i
+
n
q
o
i
+
1
2
_
__

a
i
= max
_
0, min
_
C
D
,
C
2D
+m
i+1

n
_
q
s
i
+
n
q
o
i

1
2

n
_
__

a
i
= max
_
0, min
_
C
D
,
C
2D
m
i+1

n
_
q
s
i
+
n
q
o
i
+
1
2

n
_
__
In Figures 1 and 2, we illustrate the extent to which the amount of options
in inventory, q
o
, aects the ask premium on the stock,
a
i
and on the option
a
i
,
for two dierent levels of risk aversion = 0.006 and = 0.1. Note that we
are setting q
s
= 0. Figure 1 illustrates that as q
o
increases, the premiums
a
i
and
a
i
decrease, indicating that the ask quote moves closer to the market mid
price. This eect is most dramatic on the stock quotes, where an inventory of
10 options causes the dealer to lower his ask quote aggressively to the mid price
of the stock (i.e.
a
i
= 0). In Figure 2, we see that for a very risk-averse dealer
( = 0.1), the policy on the stock is essentially in two states: an aggressive sell
state when
a
i
= 0 and a no-trade state when
a
i
= 0.02.
8
Figure 1: No intraday movement, low risk aversion ( = 0.006, q
s
= 0, A = 40,
B = 2000, C = 40, D = 200, S = 100, K = 100, = 0.01, n = 100, t
0
= 0, t
n
= 1,
T = 1.5, T
mat
= 400.)
Figure 2: No intraday movement, high risk aversion ( = 0.1, q
s
= 0, A = 40,
B = 2000, C = 40, D = 200, S = 100, K = 100, = 0.01, n = 100, t
0
= 0, t
n
= 1,
T = 1.5, T
mat
= 400.)
Also worthy of note is the time-of-the-day eect: near the end of the day
t
n
= 1, the ask quotes are more sensitive to small changes in inventory, than
at the beginning of the day. This reects the fact that at the beginning of the
day, the dealer has more chances to trade in and out of a position, while at the
end of the day, he is most likely to get stuck with his marginal inventory.
For each level of risk aversion, there is an optimal quoting strategy, given
by the premiums
a
i
,
b
i
,
a
i
and
b
i
. By simulating 1000 days with initial inven-
9
0 0.5 1 1.5 2 2.5 3 3.5 4 4.5 5
0
0.5
1
1.5
2
2.5
3
3.5
4
4.5
Standard deviation of overnight change in wealth
E
x
p
e
c
t
e
d

P
r
o
f
it
= 0.1
= 0.006 =0
Figure 3: Ecient frontier (A = 40, B = 2000, C = 40, D = 200, S = 100, K = 100,
= 0.01, n = 100, t
0
= 0, t
n
= 1, T = 1.5, T
mat
= 400.)
tory equal to zero, we obtain an ecient frontier (see Figure 3). This frontier
describes the tradeo between the expected daily prot and the standard de-
viation of the inventory value, for various levels of risk aversion. The discon-
tinuities in the frontier are due to our particular modeling of the functions
s
and
o
in (2.3) and (2.4). The prot maximizing point ( = 0) is obtained by
a risk neutral dealer whose bid-ask quotes are symmetric around the mid price,
regardless of inventory.
We identify two qualitatively dierent regions of the frontier, of which our
choices of = 0.006 and = 0.1 are representative. The low risk aversion
dealer, = 0.006 essentially treats the stock and the option as two similar
instruments by slightly moving quotes on the stock and the option, for moderate
levels of inventory (as illustrated in Figure 1). The highly risk-averse dealer,
= 0.1, uses the stock mainly as a hedging instrument by aggressively moving
the stock quotes when his Delta is non-zero (as illustrated in Figure 2). This
type of dealer would be likely to hedge options very frequently, even at the cost
of crossing the spread, essentially abandoning his role as a market maker in the
stock. We will in fact revisit dealers of this type in Section 4, by modeling a
dealer who only makes markets in the options and delta-hedges his position at
every time-step. This will require a more sophisticated modeling of the option
dynamics and will highlight the role of higher order risks, Gamma and Vega.
3.3 Multi-period model, constant volatility
We now turn to the general multi-period problem (2.6) with constant volatility.
The stock and option prices uctuate during the course of the n trading sessions.
In this case, the optimal bid and ask premiums depend on the price path and
10
we describe a Montecarlo procedure to compute the optimal stock and option
premiums. We rst condition on the entire path of the stock price:
u(X
0
, {S
j
}
(0jn)
, q
s
0
, q
0
0
, t
0
) = max

a
i
,
b
i
,
a
i
,
b
i
,0in1
_
E[Z
T
]
n

i=0
V ar[I
i
|S
j
]
_
.
Once the function u has been computed for a stock path, the value function is
simply an average of the form
v(X
0
, S
0
, q
s
0
, q
0
0
, t
0
) = E
_
u(X
0
, {S
j
}
(0jn)
, q
s
0
, q
0
0
, t
0
)
_
For each stock path, the dynamic programming principle is now
u
i
(Z
i
, q
s
i
, q
o
i
) = max

a
i
,
b
i
,
a
i
,
b
i
E[u
i+1
(Z
i+1
, q
s
i+1
, q
o
i+1
)|F
i
] V ar[I
i
|q
s
i
, q
o
i
, S
i
]
where
V ar[I
i
|q
s
i
, q
o
i
, S
i
] =
2
S
2
i
t (q
s
i
+q
o
i

i
)
2
which yields a result similar to Theorem 3.2.
Theorem 3.3. The value function at time t
i
is given by
u
i
(Z
i
, q
s
i
, q
o
i
) = Z
i
+w
i
(q
s
i
, q
o
i
)
where the function is a quadratic function of inventory
w
i
(q
s
i
, q
o
i
) = a
i
(q
s
i
)
2
+b
i
(q
o
i
)
2
+c
i
q
s
i
q
o
i
+f
i
with coecients given recursively by
a
i
= a
i+1
+ t
_
Ba
2
i+1
x +
1
4
Dc
2
i+1
y
2
S
2
i
_
b
i
= b
i+1
+ t
_
Db
2
i+1
y +
1
4
Bc
2
i+1
x
2
S
2
i

2
i
_
c
i
= c
i+1
+ t
_
Ba
i+1
c
i+1
x +Db
i+1
c
i+1
y 2
2
S
2
i

i
_
f
i
= f
i+1
+ t
_
_
A
2
4B
+
1
4
Ba
2
i+1
+
1
2
Aa
i+1
_
x +
_
C
2
4D
+
1
4
Db
2
i+1
+
1
2
Cb
i+1
_
y
Aa
i+1
_
11
{
a
i
=0}
+ 11
{
b
i
=0}
_
Cb
i+1
_
11
{
a
i
=0}
+ 11
{
b
i
=0}
__
and with terminal conditions
a
n
=
2
S
2
n
(T t
n
)
b
n
=
2
S
2
n
(T t
n
)
2
n
c
n
= 2
2
S
2
n
(T t
n
)
n
f
n
= 0.
11
Figure 4: Constant volatility ( = 0.006, A = 40, B = 2000, C = 40, D = 200,
S = 100, K = 100, = 0.01, n = 100, t
0
= 0, t
n
= 1, T = 1.5, T
mat
= 400.)
Moreover, for i < n, the optimal bid and ask premiums at time t
i
are given by

a
i
= max
_
0, min
_
A
B
,
A
2B
+a
i+1
q
s
i
+
1
2
c
i+1
q
o
i

1
2
a
i+1
__

b
i
= max
_
0, min
_
A
B
,
A
2B
a
i+1
q
s
i

1
2
c
i+1
q
o
i

1
2
a
i+1
__

a
i
= max
_
0, min
_
C
D
,
C
2D
+b
i+1
q
o
i
+
1
2
c
i+1
q
s
i

1
2
b
i+1
__

b
i
= max
_
0, min
_
C
D
,
C
2D
b
i+1
q
o
i

1
2
c
i+1
q
s
i

1
2
b
i+1
__
In Figure 4, we illustrate the eect of the option inventory on the ask pre-
miums on the stock and the option for = 0.006. Compared to Figure 1, the
sensitivity of quotes with respect to inventory is larger, especially towards the
beginning of the day. Inventory held at the beginning of the day is now viewed
as more risky from the point of view of the dealer, since he is penalized for the
variance of inventory throughout the day.
4 Gamma and Vega risk
In this section, we introduce Gamma risk, by considering risk due to discrete
hedging and Vega risk, by directly modeling the stochastic implied volatility of
the option. However, we also simplify the problem, by abandoning the dealers
12
control of the bid and ask quotes (or equivalently the controls
a
and
b
) and
assuming that the delta of his option inventory is set to zero at the beginning
of every trading period t
i
.
The market dynamics. The continuous time dynamics of the stock mid price
is given by
dS
t
=
t
S
t
dW
t
where the volatility
t
is stochastic. Here we follow the approach of Schonbucher
(1999) by directly modeling the implied volatility of the option as
d = dW
1
t
(4.1)
where the Brownian motions W
t
and W
1
t
are independent.
The dealer makes markets in a European call option with maturity T
mat
>>
T and strike K, whose mid price follows
dC
t
=
t
dt +
t
dS
t
+
1
2

t
(dS
t
)
2
+C

d
t
+
1
2
C

(d
t
)
2
where the function C(S, t) is given by the Black Scholes formula and
t
,
t
and

t
are the standard greeks. Schonbucher (1999) shows that for the choice (4.1),
the stochastic volatility of the stock must be related to the implied volatility
through the relation

2
t
=
2
t


2

2
t
_
_
ln
_
S
K
__
2

1
4
(T
mat
t)
2

4
t
_
to avoid arbitrages. Our expression for the change in option value thus becomes
C
i
=
i

i
S
i
u

t +
1
2

2
i
S
2
i
(u
2
1)t +C

t (4.2)
where u and are standard normal random variables. The second term is a
standard second order approximation (see Boyle and Emanuel (1980)), which
captures the risk of discrete hedging. The third term captures the risk of a
stochastic implied volatility. Using (4.2), the relationship between Gamma and
Vega
C

= S
2
(T
mat
t) (4.3)
and assuming that the options are delta-hedged at every time step
q
s
i
= q
o
i

i
we may use (2.1) to obtain
I
i
= q
o
i+1
_
1
2

2
i
S
2
i
(u
2
1)t +
i

i
S
2
i
(T
mat
t
i
)

t
_
. (4.4)
13
and
I
n
= q
o
n
_
1
2

2
n
S
2
n
(u
2
1)t +
n

n
S
2
n
(T
mat
t
n
)

t
_
. (4.5)
Expression (4.4) highlights the fact that for long maturity options the stochastic
volatility contribution is likely to dominate, while for short maturity options,
the risk contribution of discrete hedging will be more important.
The advantage of directly modeling the implied volatility is that it is observ-
able and that statistics on its volatility can readily be obtained. Moreover,
this approach can be generalized to a model of the entire volatility surface (see
Cont and Da Fonseca (2002)).
The objective. The new value function
v(X
0
, S
0
, q
s
0
, q
o
0
, t
0
) = max

a
i
,
b
i
,0in1
_
E[Z
T
]
n

i=0
V ar[I
i
]
_
now only depends on two controls
a
i
and
b
i
, but the inventory risk now depends
on higher order terms given in (4.4) and (4.5).
4.1 One-period model
The value function can be written as
v(X
n1
, S
n1
, q
s
n1
, q
o
n1
, t
n1
) = max

a
n1
,
b
n1
(E[Z
T
] V ar[I
T
I
n1
])
The dealers objective is to determine the optimal bid and ask quotes on the
stock and options market.
Theorem 4.1. The optimal policy for the dealer is given by

a
n1
= max
_
0, min
_
C
D
,
C
2D
k
_
q
o
n1

1
2
___

a
n1
= max
_
0, min
_
C
D
,
C
2D
+k
_
q
o
n1
+
1
2
___
where k =
_
1
2

2
n1
(T t
n1
) +
2
(T
mat
t
n1
)
2
_

2
n1
S
4
n1

2
n1
(T t
n1
)
Remark 4.1. In the risk neutral case where = 0, the objective is to maximize
terminal wealth and the optimal premium is
=
C
2D
regardless of inventory.
Remark 4.2. Notice that if the dealer is risk-averse, i.e. > 0, he adjusts or
tilts all his quotes away from the prot maximizing solution by an amount
proportional to the net option position, q
o
n1
.
14
4.2 Multi-period model
Much like in Section 3.2, we may use the dynamic programming principle to
solve the multi-period model in the setting with no intraday movement. The
value function simplies to
v(X
0
, S
0
, q
s
0
, q
o
0
, t
0
) = max

a
i
,
b
i
,0in1
(E[Z
T
] V ar[I
n
])
and can be computed by applying the following result, analogous to Theorem
3.2.
Theorem 4.2. The value function at time t
i
is given by
v
i
(Z
i
, q
s
i
, q
o
i
) = Z
i
+w
i
(q
o
i
)
where w
i
is a quadratic function of inventory
w
i
(q
o
i
) = m
i
(q
o
i
)
2
+f
i
where a
i
,b
i
, c
i
and f
i
are given recursively by
m
i
= m
i+1
+ t
_
Dm
2
i+1
y
_
f
i
= f
i+1
+ t
_
_
C
2
4D
+
1
4
Dm
2
i+1
+
1
2
Cm
i+1
_
y Cm
i+1
_
11
{
a
i
=0}
+ 11
{
b
i
=0}
__
where y =
_
11
{0<
b
i
<
C
D
}
+ 11
{0<
b
i
<
C
D
}
_
and terminal conditions are
m
n
=
2
n
S
2

2
n
(T t
n
)
_
1
2

2
n
S
2
(T t
n
) +
2
S
2
(T
mat
t
n
)
2
_
f
n
= 0.
Moreover, the optimal bid and ask premiums at time t
i
are given by

a
i
= max
_
0, min
_
C
D
,
C
2D
+m
i+1
q
o
i

1
2
m
i+1
__

b
i
= max
_
0, min
_
C
D
,
C
2D
m
i+1
q
o
i

1
2
m
i+1
__
.
15
Figure 5: Long maturity option for = 0 and = 0.00035 ( = 0.1, A = 40,
B = 2000, C = 40, D = 200, S = 100,
0
= 0.01, n = 100, t
0
= 0, t
n
= 1, T = 1.5,
T
mat
= 400.)
Figure 6: Short maturity option for = 0 and = 0.00035 ( = 0.1, A = 40,
B = 2000, C = 40, D = 200, S = 100,
0
= 0.01, n = 100, t
0
= 0, t
n
= 1, T = 1.5,
T
mat
= 2.)
16
In Figure 5 and Figure 6, we illustrate the eect of the maturity, T
mat
, and
the volatility of implied volatility, , on the option ask premiums. In Figure 5,
we notice that for long maturity options, the magnitude of has an important
impact on the sensitivity of the quotes with respect to inventory. This reects
the fact Vega risk is more important than Gamma risk for long maturity options.
However, when time-to-maturity is short, Gamma risk dominates and the
parameter has virtually no eect on the optimal quoting policy (see Figure 6).
5 Conclusion
We solve two related mean-variance optimization problems for a market maker
in European options. The dealer has control over bid and ask quotes and
maximizes expected returns over a one day period, with a penalty that is pro-
portional to the variance of the inventory value.
In the rst problem, we model the dealer as an agent who simultaneously
updates bid and ask quotes on a European call option and its underlying stock.
The mid prices of the stock and the option are related by the Black-Scholes
formula. This modeling choice highlights the importance of keeping the net
Delta of the inventory under control. Since we model the liquidity of the stock
to be greater than that of the option, we nd that the optimal strategy is to
set a large bid-ask spread around the option mid price and move the stock
quotes aggressively as the dealers net Delta departs from zero. By varying
the coecient of risk aversion, we are able to numerically compute the ecient
frontier of the dealer. Furthermore, we generalize our problem to a setting
where the penalty term also depends on the variance of intraday returns.
In the second problem, we model a dealer who Delta hedges the option
inventory with the stock at every time step, but is subject to residual risks
due to stochastic volatility and overnight moves in the stock price. These risks
highlight the need to keep the Vega and Gamma of the dealers inventory under
control, and this is reected in the dealers quoting strategy. We illustrate this
optimal quoting policy for options of varying maturity. We nd that the dealers
net Gamma dominates the quoting policy for short maturity options, while the
net Vega dominates the quoting policy for the long maturity options.
17
References
[1] Almgren, R. and Chriss, N. (2001), Optimal Execution of Portfolio Trans-
actions, Journal of Risk, 3: 5-39.
[2] Boyle, P. and Emanuel, D. (1980), Discretely Adjusted Option Hedges,
Journal of Financial Economics, 8: 259-282.
[3] Cont, R. and da Fonseca, J. (2002), Dynamics of Implied Volatility Sur-
faces, Quantitative Finance, 2: 45-60.
[4] Engle, R. and Ferstenberg, R. (2006), Execution Risk, Working paper.
[5] Garleanu, N., Pedersen, L. H. and Poteshman, A. M. (2006), Demand
Based Option Pricing, Working Paper, Wharton School of Business.
[6] Hasbrouck, J. (2007), Empirical Market Microstructure, Oxford Univer-
sity Press.
[7] Ho, T. S. Y. and Macris, R. G. (1984), Dealer Bid-Ask Quotes and Trans-
action Prices: An Empirical Study of Some AMEX Options, Journal of
Finance, 39(1), 23-45.
[8] Ho, T. S. Y. and Stoll H. R. (1981), Optimal Dealer Pricing under Trans-
actions and Return Uncertainty, Journal of Financial Economics, 9, 47-73.
[9] Jameson, M. and Wilhelm, W. (1992), Market Making in the Options
Markets and the Costs of Discrete Hedge Rebalancing, Journal of Finance,
47, 765-779.
[10] Schonbucher, P. J. (1999) A Market Model for Stochastic Implied Volatil-
ity, Philosophical Transactions: Mathematical, Physical and Engineering
Sciences, 357(1758), 2071-2092.
18
Appendix
Proof of Theorem 3.1. Lets rst write down the expected wealth
E[Z
T
|F
i
] = Z
n1
+E[Z
n1
|F
n1
] +E[I
n1
+ I
n
|F
n1
]
= Z
n1
+ t
_

s
(
a
) +
b

s
(
b
) +
a

o
(
a
) +
b

o
(
b
)
_
We then compute the variance terms
V ar
_
I
n1
+ I
n
|F
n1
_
= E
_
V ar
_
I
n1
+ I
n
|q
s
n
, q
o
n
, S
n1
_
|q
s
n1
, q
o
n1
, S
n1
_
= E
_
V ar
_
q
s
n
(S
T
S
n1
) +q
o
n
(C
T
C
n1
)|q
s
n
, q
o
n
, S
n1
_
|q
s
n1
, q
o
n1
, S
n1
_
= E
__
q
s
n
S
n1
+q
o
n
S
n1

n1
_
2
(T t
n1
)|q
s
n1
, q
o
n1
, S
n1
_
=
s
(
a
)t
_
(q
s
n1
1)S
n1
+q
o
n1
S
n1

n1
_
2
(T t
n1
)
+
s
(
b
)t
_
(q
s
n1
+ 1)S
n1
+q
o
n1
S
n1

n1
_
2
(T t
n1
)
+
o
(
a
)t
_
q
s
n1
S
n1
+ (q
o
n1
1)S
n1

n1
_
2
(T t
n1
)
+
s
(
b
)t
_
q
s
n1
S
n1
+ (q
o
n1
+ 1)S
n1

n1
_
2
(T t
n1
)
+(1
s
(
a
)t
s
(
b
)t
o
(
a
)t
o
(
b
)t)
_
(q
s
n1
S
n1
+q
o
n1
S
n1

n1
)
_
2
(T t
n1
)
which equals after cancelations:
= (T t
n1
)
_

s
(
a
)t
_
(2q
s
n1
+ 1)
2
S
2
n1
2q
o
n1

2
S
2
n1

n1
_
+
s
(
b
)t
_
(2q
s
n1
+ 1)
2
S
2
n1
+ 2q
o
n1

2
S
2
n1

n1
_
+
o
(
a
)t
_
(2q
o
n1
+ 1)
2
S
2
n1

2
n1
2q
s
n1

2
S
2
n1

n1
_
+
o
(
b
)t
_
(2q
o
n1
+ 1)
2
S
2
n1

2
n1
+ 2q
s
n1

2
S
2
n1

n1
_
+
_
(q
s
n1
)
2

2
S
2
n1
+ (q
o
n1
)
2

2
S
2
n1

2
n1
+ 2q
s
n1
q
o
n1

2
S
2
n1

n1
__
Using the above formulas, then v(X
n1
, S
n1
, q
s
n1
, q
o
n1
, t
n1
) equals:
max

a
n1
,
b
n1
,
a
n1
,
b
n1
__
Y
n1
+ t
_

s
(
a
) +
b

s
(
b
) +
a

o
(
a
) +
b

o
(
b
)
__
(T t
n1
)
_

s
(
a
)t
_
(2q
s
n1
+ 1)
2
S
2
n1
2q
o
n1

2
S
2
n1

n1
_
+
s
(
b
)t
_
(2q
s
n1
+ 1)
2
S
2
n1
+ 2q
o
n1

2
S
2
n1

n1
_
+
o
(
a
)t
_
(2q
o
n1
+ 1)
2
S
2
n1

2
n1
2q
s
n1

2
S
2
n1

n1
_
+
o
(
b
)t
_
(2q
o
n1
+ 1)
2
S
2
n1

2
n1
+ 2q
s
n1

2
S
2
n1

n1
_
+
_
(q
s
n1
)
2

2
S
2
n1
+ (q
o
n1
)
2

2
S
2
n1

2
n1
+ 2q
s
n1
q
o
n1

2
S
2
n1

n1
__
_
19
By taking the rst order conditions, we can solve for each bid and ask quote
for both the option and the stock:

a
n1
= max
_
0, min
_
A
B
,
A
2B

2
(T t
n1
)S
2
n1
_
q
s
n1
+q
o
n1

n1

1
2
___

b
n1
= max
_
0, min
_
A
B
,
A
2B
+
2
(T t
n1
)S
2
n1
_
q
s
n1
+q
o
n1

n1
+
1
2
___

a
n1
= max
_
0, min
_
C
D
,
C
2D

2
(T t
n1
)S
2
n1

n1
_
q
s
n1
+q
o
n1

n1

1
2

n1
___

a
n1
= max
_
0, min
_
C
D
,
C
2D
+
2
(T t
n1
)S
2
n1

n1
_
q
s
n1
+q
o
n1

n1
+
1
2

n1
___
Proof of Theorem 3.2. We need the following lemmas to prove Theorem 3.2.
Lemma 5.1. Let x =
_
11
{0<
a
k
<
A
B
}
+ 11
{0<
b
k
<
A
B
}
_
and y =
_
11
{0<
a
k
<
C
D
}
+ 11
{0<
b
k
<
C
D
}
_
.
Then, v
i
(Z
i
, q
s
i
, q
o
i
) = Z
i
+ w
i
(q
s
i
, q
o
i
) and w
i
(q
s
i
, q
o
i
) is a quadratic function of
inventory in the form
a
i
(q
s
i
)
2
+b
i
(q
o
i
)
2
+c
i
q
s
i
q
o
i
+d
i
q
s
i
+e
i
q
o
i
+f
i
For k < n, we have
a
k
= a
k+1
+ t
_
Ba
2
k+1
x +
1
4
Dc
2
k+1
y
_
b
k
= b
k+1
+ t
_
Db
2
k+1
y +
1
4
Bc
2
k+1
x
_
c
k
= c
k+1
+ t (Ba
k+1
c
k+1
x +Db
k+1
c
k+1
y)
d
k
= d
k+1
+ t
_
Ba
k+1
d
k+1
x +
1
4
Dc
k+1
e
k+1
y
_
e
k
= e
k+1
+ t
_
Db
k+1
e
k+1
y +
1
4
Bc
k+1
d
k+1
x
_
f
k
= f
k+1
+ t
_
_
A
2
4B
+
1
4
B
_
a
2
k+1
+d
2
k+1
_
+
1
2
Aa
k+1
_
x
+
_
C
2
4D
+
1
4
D
_
b
2
k+1
+e
2
k+1
_
+
1
2
Cb
k+1
_
y
Aa
k+1
_
11
{
a
k
=0}
+ 11
{
b
k
=0}
_
Cb
k+1
_
11
{
a
k
=0}
+ 11
{
b
k
=0}
__
20
and

a
k
= max
_
0, min
_
A
B
,
A
2B
+a
k+1
q
s
k
+
1
2
c
k+1
q
o
k

1
2
a
k+1
+
1
2
d
k+1
__

b
k
= max
_
0, min
_
A
B
,
A
2B
a
k+1
q
s
k

1
2
c
k+1
q
o
k

1
2
a
k+1

1
2
d
k+1
__

a
k
= max
_
0, min
_
C
D
,
C
2D
+b
k+1
q
o
k
+
1
2
c
k+1
q
s
k

1
2
b
k+1
+
1
2
e
k+1
__

b
k
= max
_
0, min
_
C
D
,
C
2D
b
k+1
q
o
k

1
2
c
k+1
q
s
k

1
2
b
k+1

1
2
e
k+1
__
Proof. This lemma can be proven by induction.
Base case: If i = n, then
v
n
(Z
n
, q
s
n
, q
o
n
) = Z
n

2
S
2
n
(T t
n
)
_
q
s
i
+q
o
i

n
_
2
which implies that
a
n
=
2
S
2
(T t
n
)
b
n
=
2
S
2

2
n
(T t
n
)
c
n
= 2
2
S
2

n
(T t
n
)
d
n
= 0
e
n
= 0.
Inductive step: Suppose Lemma 5.1 holds for i = k + 1 where 0 < k + 1 n.
Then for i = k, we use
v
k
(Z
k
, q
s
k
, q
o
k
) = max

a
k
,
b
k
,
a
k
,
b
k
E[v
k+1
(Z
k+1
, q
s
k+1
, q
o
k+1
)|F
k
]
Using induction hypothesis, v
k
(Z
k
, q
s
k
, q
o
k
) equals
= max

a
k
,
b
k
,
a
k
,
b
k
E
_
Z
k+1
+a
k+1
(q
s
k
)
2
+b
k+1
(q
o
k
)
2
+c
k+1
q
s
k
q
o
k
+d
k+1
q
s
k
+e
k+1
q
o
k
+f
k+1
|Z
k
, q
s
k
, q
o
k
_
= Z
k
+
_

a
k

s
(
a
k
) +
b
k

s
(
b
k
) +
a
k

o
(
a
k
) +
b
k

o
(
b
k
)
_
t
+
s
(
a
k
)t
_
a
k+1
(q
s
k
1)
2
+b
k+1
(q
o
k
)
2
+c
k+1
(q
s
k
1)q
o
k
+d
k+1
(q
s
k
1) +e
k+1
q
o
k
+f
k+1
_
+
s
(
b
k
)t
_
a
k+1
(q
s
k
+ 1)
2
+b
k+1
(q
o
k
)
2
+c
k+1
(q
s
k
+ 1)q
o
k
+d
k+1
(q
s
k
+ 1) +e
k+1
q
o
k
+f
k+1
_
+
o
(
a
k
)t
_
a
k+1
(q
s
k
)
2
+b
k+1
(q
o
k
1)
2
+c
k+1
q
s
k
(q
o
k
1) +d
k+1
q
s
k
+e
k+1
(q
o
k
1) +f
k+1
_
+
s
(
b
k
)t
_
a
k+1
(q
s
k
)
2
+b
k+1
(q
o
k
+ 1)
2
+c
k+1
q
s
k
(q
o
k
+ 1) +d
k+1
q
s
k
+e
k+1
(q
o
k
+ 1) +f
k+1
_
+(1
s
(
a
k
)t
s
(
b
k
)t
o
(
a
k
)t
o
(
b
k
)t)
_
a
k+1
(q
s
k
)
2
+b
k+1
(q
o
k
)
2
+c
k+1
q
s
k
q
o
k
+d
k+1
q
s
k
+e
k+1
q
o
k
+f
k+1
_
21
= Z
k
+
_

a
k

s
(
a
k
) +
b
k

s
(
b
k
) +
a
k

o
(
a
k
) +
b
k

o
(
b
k
)
_
t
+
s
(
a
k
)t
_
a
k+1
(2q
s
k
+ 1) c
k+1
q
o
k
d
k+1
_
+
s
(
b
k
)t
_
a
k+1
(2q
s
k
+ 1) +c
k+1
q
o
k
+d
k+1
_
+
o
(
a
k
)t
_
b
k+1
(2q
o
k
+ 1) c
k+1
q
s
k
e
k+1
_
+
s
(
b
k
)t
_
b
k+1
(2q
o
k
+ 1) +c
k+1
q
s
k
+e
k+1
_
+
_
a
k+1
(q
s
k
)
2
+b
k+1
(q
o
k
)
2
+c
k+1
q
s
k
q
o
k
+d
k+1
q
s
k
+e
k+1
q
o
k
+f
k+1
_
taking rst order conditions in

a
k
(AB
a
k
) + (AB
a
k
)
_
2a
k+1
q
s
k
c
k+1
q
o
k
+a
k+1
d
k+1
_

a
k
(AB
b
k
) + (AB
b
k
)
_
2a
k+1
q
s
k
+c
k+1
q
o
k
+a
k+1
+d
k+1
_

a
k
(C D
a
k
) + (C D
a
k
)
_
2b
k+1
q
o
k
c
k+1
q
s
k
+b
k+1
e
k+1
_

b
k
(C D
b
k
) + (C D
b
k
)
_
2b
k+1
q
o
k
+c
k+1
q
s
k
+b
k+1
+e
k+1
_
obtains

a
k
= max
_
0, min
_
A
B
,
A
2B
+a
k+1
q
s
k
+
1
2
c
k+1
q
o
k

1
2
a
k+1
+
1
2
d
k+1
__

b
k
= max
_
0, min
_
A
B
,
A
2B
a
k+1
q
s
k

1
2
c
k+1
q
o
k

1
2
a
k+1

1
2
d
k+1
__

a
k
= max
_
0, min
_
C
D
,
C
2D
+b
k+1
q
o
k
+
1
2
c
k+1
q
s
k

1
2
b
k+1
+
1
2
e
k+1
__

b
k
= max
_
0, min
_
C
D
,
C
2D
b
k+1
q
o
k

1
2
c
k+1
q
s
k

1
2
b
k+1

1
2
e
k+1
__
22
substituting back in the value function yields
v
k
(Z
k
, q
s
k
, q
o
k
) = Z
k
+ 11
{0<
a
k
<
A
B
}
Bt
_
A
2B
a
k+1
q
s
k

1
2
c
k+1
q
o
k
+
1
2
a
k+1

1
2
d
k+1
_
2
11
{
a
k
=0}
2At
_
a
k+1
q
s
k

1
2
c
k+1
q
o
k
+
1
2
a
k+1

1
2
d
k+1
_
+ 11
{0<
b
k
<
A
B
}
Bt
_
A
2B
+a
k+1
q
s
k
+
1
2
c
k+1
q
o
k
+
1
2
a
k+1
+
1
2
d
k+1
_
2
11
{
b
k
=0}
2At
_
a
k+1
q
s
k
+
1
2
c
k+1
q
o
k
+
1
2
a
k+1
+
1
2
d
k+1
_
+ 11
{0<
a
k
<
C
D
}
Dt
_
C
2D
b
k+1
q
o
k

1
2
c
k+1
q
s
k
+
1
2
b
k+1

1
2
e
k+1
_
2
11
{
a
k
=0}
2Ct
_
b
k+1
q
o
k

1
2
c
k+1
q
s
k
+
1
2
b
k+1

1
2
e
k+1
_
+ 11
{0<
b
k
<
C
D
}
Dt
_
C
2D
+b
k+1
q
o
k
+
1
2
c
k+1
q
s
k
+
1
2
b
k+1
+
1
2
e
k+1
_
2
11
{
b
k
=0}
2Ct
_
b
k+1
q
o
k
+
1
2
c
k+1
q
s
k
+
1
2
b
k+1
+
1
2
e
k+1
_
+
_
a
k+1
(q
s
k
)
2
+b
k+1
(q
o
k
)
2
+c
k+1
q
s
k
q
o
k
+d
k+1
q
s
k
+e
k+1
q
o
k
+f
k+1
_
This shows that v
k
(Z
k
, q
s
k
, q
o
k
) is a quadratic function of inventory with the
following coecients.
a
k
= a
k+1
+ t
_
Ba
2
k+1
x +
1
4
Dc
2
k+1
y
_
b
k
= b
k+1
+ t
_
Db
2
k+1
y +
1
4
Bc
2
k+1
x
_
c
k
= c
k+1
+ t (Ba
k+1
c
k+1
x +Db
k+1
c
k+1
y)
d
k
= d
k+1
+ t
_
Ba
k+1
d
k+1
x +
1
4
Dc
k+1
e
k+1
y
_
e
k
= e
k+1
+ t
_
Db
k+1
e
k+1
y +
1
4
Bc
k+1
d
k+1
x
_
f
k
= f
k+1
+ t
_
_
A
2
4B
+
1
4
B
_
a
2
k+1
+d
2
k+1
_
+
1
2
Aa
k+1
_
x
+
_
C
2
4D
+
1
4
D
_
b
2
k+1
+e
2
k+1
_
+
1
2
Cb
k+1
_
y
Aa
k+1
_
11
{
a
k
=0}
+ 11
{
b
k
=0}
_
Cb
k+1
_
11
{
a
k
=0}
+ 11
{
b
k
=0}
__
Lemma 5.2.
b
i
= a
i

2
n
c
i
= 2a
i

n
d
i
= e
i
= 0.
23
Proof. This lemma can also be proven by induction.
Base case: If i = n, then
a
n
=
2
S
2
(T t
n
)
b
n
= a
n

2
n
c
n
= 2a
n

n
d
n
= 0
e
n
= 0.
Inductive step: Suppose Lemma 5.2 holds for i = k + 1 where 0 < k + 1 n.
Then for i = k, we use the following identities from Lemma 5.1.
b
k
= b
k+1
+ t
_
Db
2
k+1
y +
1
4
Bc
2
k+1
x
_
c
k
= c
k+1
+ t (Ba
k+1
c
k+1
x +Db
k+1
c
k+1
y)
d
k
= d
k+1
+ t
_
Ba
k+1
d
k+1
x +
1
4
Dc
k+1
e
k+1
y
_
e
k
= e
k+1
+ t
_
Db
k+1
e
k+1
x +
1
4
Bc
k+1
d
k+1
y
_
Using induction hypothesis,
b
k
= a
k+1

2
n
+ t
_
yD
_
a
k+1

2
n
_
2
+
1
4
xB(2a
k+1

n
)
2
_
=
2
n
_
a
k+1
+ t
_
xBa
2
k+1
+
1
4
yDc
2
k+1
__
=
2
n
a
k
c
k
= a
k+1

n
+ t
_
xBa
k+1
a
k+1

n
+yDa
k+1

2
n
a
k+1

n
_
= 2
n
_
a
k+1
+ t
_
xBa
2
k+1
+
1
4
yc
2
k+1
__
= 2
n
a
k
d
k
= d
k+1
+ t
_
xBa
k+1
d
k+1
+
1
4
yDc
k+1
e
k+1
_
= 0 + t
_
xBa
k+1
0 +
1
4
yDc
k+1
0
_
= 0
e
k
= e
k+1
+ t
_
yDb
k+1
e
k+1
+
1
4
xBc
k+1
d
k+1
_
= 0 + t
_
yDb
k+1
0 +
1
4
xc
k+1
0
_
= 0
24
By using Lemma 5.1 and Lemma 5.2, and letting m
i
= a
i
, we get
m
i
= m
i+1
+ t
_
Bm
2
i+1
_
11
{0<
a
i
<
A
B
}
+ 11
{0<
b
i
<
A
B
}
_
+D
2
n
m
2
i+1
_
11
{0<
b
i
<
C
D
}
+ 11
{0<
b
i
<
C
D
}
__
f
i
= f
i+1
+ t
_
_
A
2
4B
+
1
4
Bm
2
i+1
+
1
2
Am
i+1
_
_
11
{0<
a
i
<
A
B
}
+ 11
{0<
b
i
<
A
B
}
_
+
_
C
2
4D
+
1
4
Dm
2
i+1

4
n
+
1
2
Cm
i+1

2
n
_
_
11
{0<
b
i
<
C
D
}
+ 11
{0<
b
i
<
C
D
}
_
Am
i+1
_
11
{
a
i
=0}
+ 11
{
b
i
=0}
_
Cm
i+1

2
n
_
11
{
b
i
=0}
+ 11
{
b
i
=0}
__
and for i < n, the optimal bid and ask premiums at time t
i
are given by

a
i
= max
_
0, min
_
A
B
,
A
2B
+m
i+1
_
q
s
i
+
n
q
o
i

1
2
_
__

b
i
= max
_
0, min
_
A
B
,
A
2B
m
i+1
_
q
s
i
+
n
q
o
i
+
1
2
_
__

a
i
= max
_
0, min
_
C
D
,
C
2D
+m
i+1

n
_
q
s
i
+
n
q
o
i

1
2

n
_
__

a
i
= max
_
0, min
_
C
D
,
C
2D
m
i+1

n
_
q
s
i
+
n
q
o
i
+
1
2

n
_
__
Theorem 3.3. The value function in the constant volatility case can be written
in terms of the value function in Theorem 3.2:
u
i
(Z
i
, q
s
i
, q
o
i
) = v
i
(Z
i
, q
s
i
, q
o
i
) V ar[I
i
|q
s
i
, q
o
i
, S
i
]
= Z
i
+w
i
(q
s
i
, q
o
i
)
2
S
2
i
t
_
(q
s
i
)
2
+ 2
i
q
s
i
q
o
i
+
2
i
(q
o
i
)
2
_
= Z
i
+
_
a
i

2
S
2
i
_
(q
s
i
)
2
+
_
b
i

2
S
2
i

2
i
_
(q
o
i
)
2
+
_
c
i
2
2
S
2
i

i
_
(q
s
i
q
o
i
)
where a
i
, b
i
and c
i
are derived in Lemma 5.1.
Proof of Theorem 4.1. We rst write down the expected wealth
E[Z
T
|F
n1
] = Z
n1
+E[Z
n1
|F
n1
] +E[I
n
+ I
n1
|F
n1
]
= Z
n1
+ t
_

o
(
a
) +
b

o
(
b
)
_
We then compute the variance terms, by using the law of total variance, ap-
25
plying (4.4) and (4.5) and simplifying
V ar
_
I
n
+ I
n1
|F
n1
_
= E
_
V ar
_
I
n
+ I
n1
|q
o
n
, S
n1
_
|
n1
, q
o
n1
, S
n1
_
= E
__
1
2
q
o
n

n1
S
2
n1

2
n1
(u
2
1)(T t
n1
)
_
2
|
n1
q
o
n1
, S
n1
_
+E
__
q
o
n

n1

n1
S
2
n1
(T
mat
t
n1
)
_
2
(T t
n1
)|
n1
, q
o
n1
, S
n1
_
=
o
(
a
)t
__
(q
o
n1
1)
2
n1
S
2
n1

n1
_
2
1
2
(T t
n1
)
2
+
_
(q
o
n1
1)
2
n1
S
2
n1

n1
(T
mat
t
n1
)
_
2
(T t
n1
)
_
+
o
(
b
)t
__
(q
o
n1
+ 1)
2
n1
S
2
n1

n1
_
2
1
2
(T t
n1
)
2
+
_
(q
o
n1
+ 1)
2
n1
S
2
n1

n1
(T
mat
t
n1
)
_
2
(T t
n1
)
_
+
_
1
o
(
a
)t
o
(
b
)t
___
q
o
n1

2
n1
S
2
n1

n1
_
2
1
2
(T t
n1
)
2
+
_
q
o
n1

2
n1
S
2
n1

n1
(T
mat
t
n1
)
_
2
(T t
n1
)
_
which equals after cancelations:
=
2
n1
S
4
n1

2
n1
(T t
n1
)
_

o
(
a
)t
_
(2q
o
n1
+ 1)
_
1
2

2
n1
(T t
n1
) +
2
(T
mat
t
n1
)
2
__
+
o
(
b
)t
_
(2q
o
n1
+ 1)
_
1
2

2
n1
(T t
n1
) +
2
(T
mat
t
n1
)
2
__
+(q
o
n
)
2
_
1
2

2
n1
(T t
n1
) +
2
(T
mat
t
n1
)
2
_
_
Using the above formulas, v(X
n1
, S
n1
, q
s
n1
, q
o
n1
, t
n1
) equals:
max

a
n1
,
b
n1
_
Y
n1
+ t
_

o
(
a
) +
b

o
(
b
)
_

2
n1
S
4
n1

2
n1
(T t
n1
)
_

o
(
a
)t
_
(2q
o
n1
+ 1)
_
1
2

2
n1
(T t
n1
) +
2
(T
mat
t
n1
)
2
__
+
o
(
b
)t
_
(2q
o
n1
+ 1)
_
1
2

2
n1
(T t
n1
) +
2
(T
mat
t
n1
)
2
__
+(q
o
n
)
2
_
1
2

2
n1
(T t
n1
) +
2
(T
mat
t
n1
)
2
_
_
_
By taking the rst order conditions, we can solve for each bid and ask quote
for the option:

a
n1
= max
_
0, min
_
C
D
,
C
2D
k
_
q
o
n1

1
2
___

a
n1
= max
_
0, min
_
C
D
,
C
2D
+k
_
q
o
n1
+
1
2
___
where k =
_
1
2

2
n1
(T t
n1
) +
2
(T
mat
t
n1
)
2
_

2
n1
S
4
n1

2
n1
(T t
n1
)
Proof of Theorem 4.2. This proof is very similar to that of Theorem 3.2 and it
can also be proven by induction.
Base case: If i = n, then
v
n
(Z
n
, q
o
n
) = Z
n
(q
o
n
)
2

2
n
S
2

2
n
(T t
n
)
_
1
2

2
n
S
2
(T t
n
) +
2
S
2
(T
mat
t
n
)
2
_
26
which implies that
m
n
=
2
n
S
2

2
n
(T t
n
)
_
1
2

2
n
S
2
(T t
n
) +
2
S
2
(T
mat
t
n
)
2
_
Inductive step: Suppose Theorem 4.2 holds for i = k + 1 where 0 < k + 1 n.
Then for i = k, we use
v
k
(Z
k
, q
o
k
) = max

a
k
,
b
k
E[v
k+1
(Z
k+1
, q
o
k+1
)|F
k
]
Using induction hypothesis, v
k
(Z
k
, q
o
k
) equals
= max

a
k
,
b
k
E
_
Z
k+1
+m
k+1
(q
o
k
)
2
+f
k+1
|Z
k
, q
o
k
_
= Z
k
+
_

a
k

o
(
a
k
) +
b
k

o
(
b
k
)
_
t +
o
(
a
k
)t
_
m
k+1
(q
o
k
1)
2
+f
k+1
_
+
s
(
b
k
)t
_
m
k+1
(q
o
k
+ 1)
2
+f
k+1
_
+ (1
o
(
a
k
)t
o
(
b
k
)t)
_
m
k+1
(q
o
k
)
2
+f
k+1
_
= max

a
k
,
b
k
E
_
Z
k+1
+m
k+1
(q
o
k
)
2
+f
k+1
|Z
k
, q
o
k
_
= Z
k
+
_

a
k

o
(
a
k
) +
b
k

o
(
b
k
)
_
t +
o
(
a
k
)t
_
m
k+1
(2q
o
k
+ 1)
_
+
s
(
b
k
)t
_
m
k+1
(2q
o
k
+ 1)
_
+
_
m
k+1
(q
o
k
)
2
+f
k+1
_
taking rst order conditions in

a
k
(C D
a
k
) + (C D
a
k
)
_
2m
k+1
q
o
k
_

b
k
(C D
b
k
) + (C D
b
k
)
_
2m
k+1
q
o
k
_
obtains

a
k
= max
_
0, min
_
C
D
,
C
2D
+m
k+1
q
o
i

1
2
m
k+1
__

b
k
= max
_
0, min
_
C
D
,
C
2D
m
k+1
q
o
i

1
2
m
k+1
__
substituting back in the value function yields
v
k
(Z
k
, q
o
k
) = Z
k
+ 11
{0<
a
k
<
C
D
}
Dt
_
C
2D
m
k+1
q
o
k
+
1
2
b
k+1
_
2
11
{
a
k
=0}
2Ct
_
m
k+1
q
o
k
+
1
2
m
k+1
_
+ 11
{0<
b
k
<
C
D
}
Dt
_
C
2D
+m
k+1
q
o
k
+
1
2
m
k+1
_
2
11
{
b
k
=0}
2Ct
_
m
k+1
q
o
k
+
1
2
m
k+1
_
+
_
m
k+1
(q
o
k
)
2
+f
k+1
_
This shows that v
k
(Z
k
, q
o
k
) is a quadratic function of inventory with the follow-
ing coecients.
m
k
= m
k+1
+ t
_
Dm
2
k+1
y
_
f
k
= f
k+1
+ t
_
_
C
2
4D
+
1
4
Dm
2
k+1
+
1
2
Cm
k+1
_
y Cm
k+1
_
11
{
a
k
=0}
+ 11
{
b
k
=0}
__
27