Intraday market making with overnight inventory costs

Adrian, Tobias; Capponi, Agostino; Fleming, Michael J.; Vogt, Erik; Zhang, Hongzhong

Report

Intraday market making with overnight inventory costs

Abstract: The U.S. Treasury market is highly intermediated by nonbank principal trading ﬁrms (PTFs). Limited capital forces PTFs to end the trading day roughly ﬂat. We construct a continuous time market making model to analyze the trade-oﬀ faced by a proﬁt-maximizing ﬁrm with overnight inventory costs, and develop closed-form representations of the optimal price policy functions. Our model reveals that bid-ask spreads widen as the end of the trading day approaches, and that increases in order arrival rates do not always lead to higher price volatility. Our empirical analysis shows that Treasury security trading costs increase as the close of trading approaches, consistent with model predictions.

Keywords: market microstructure theory; market liquidity; market making; financial intermediation;

JEL Classification: G12; G17; G23;