Dealing with multi-currency inventory risk in FX cash markets

TL;DR

This paper presents a mathematical framework for FX market makers to optimize profits while managing multi-currency inventory risk, incorporating scalable approximation methods for practical implementation.

Contribution

It introduces a novel mathematical model and scalable approximation techniques for inventory risk management in multi-currency FX markets.

Findings

Framework enables profit maximization with risk control

Approximation methods improve scalability to many currency pairs

Provides practical tools for FX dealers to manage inventory risk

Abstract

In FX cash markets, market makers provide liquidity to clients for a wide variety of currency pairs. Because of flow uncertainty and market volatility, they face inventory risk. To mitigate this risk, they typically skew their prices to attract or divert the flow and trade with their peers on the dealer-to-dealer segment of the market for hedging purposes. This paper offers a mathematical framework to FX dealers willing to maximize their expected profit while controlling their inventory risk. Approximation techniques are proposed which make the framework scalable to any number of currency pairs.