Market making by an FX dealer: tiers, pricing ladders and hedging rates for optimal risk control

TL;DR

This paper develops an optimal control framework for FX market making, balancing internalization and externalization strategies to manage risk, costs, and market impact effectively.

Contribution

It introduces a novel model that jointly optimizes pricing and hedging decisions for FX dealers, addressing the internalization versus externalization dilemma.

Findings

Optimal hedging strategies reduce inventory risk.

Pricing adjustments can improve dealer profitability.

Trade-offs between transaction costs and risk mitigation are quantified.

Abstract

Dealers make money by providing liquidity to clients but face flow uncertainty and thus price risk. They can efficiently skew their prices and wait for clients to mitigate risk (internalization), or trade with other dealers in the open market to hedge their position and reduce their inventory (externalization). Of course, the better control associated with externalization comes with transaction costs and market impact. The internalization vs. externalization dilemma has been a topic of recent active discussion within the foreign exchange (FX) community. This paper offers an optimal control framework for market making tackling both pricing and hedging, thus answering a question well known to dealers: `to hedge, or not to hedge?'