Market Making and Transient Impact in Spot FX

TL;DR

This paper investigates the dynamics of market making in spot FX, focusing on the transient nature of market impact and its effects on risk management and impact resilience.

Contribution

It introduces an intermediate impact model that captures the transient effects between instantaneous and permanent impacts in FX markets.

Findings

Transient impact significantly influences optimal quoting strategies.

Resilience of impact affects risk management decisions.

Intermediate impact models better fit empirical data.

Abstract

Dealers in foreign exchange markets provide bid and ask prices to their clients at which they are happy to buy and sell, respectively. To manage risk, dealers can skew their quotes and hedge in the interbank market. Hedging offers certainty but comes with transaction costs and market impact. Optimal market making with execution has previously been addressed within the Almgren-Chriss market impact model, which includes instantaneous and permanent components. However, there is overwhelming empirical evidence of the transient nature of market impact, with instantaneous and permanent impacts arising as the two limiting cases. In this note, we consider an intermediate scenario and study the interplay between risk management and impact resilience.