Option Market Making with Inventory Risk: The Effect on Information Diffusion

Abstract

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.