Stern Center for Research Computing

New York University • Leonard Stern School of Business

The Impact of Hedging Costs on the Bid and Ask Spread in the Options Market

Title The Impact of Hedging Costs on the Bid and Ask Spread in the Options Market
Authors: Robert Engle and Breno Neri
Date: Working Paper, Revised February 3, 2010
Abstract It is well known that the bid and ask spread in the stock market can
be decomposed in three components representing the costs of market
making: the order processing cost, the cost of carrying an inventory
and the cost of trading against informed traders. In this paper we
argue that, in the options market, there is a fourth kind of cost that
the market maker faces, which is the hedging cost. More specifically,
we show that the hedging cost, further decomposed between the cost
of initially setting up the hedging position (which is proportional to
the percentage delta and to the spread of the underlying asset) and
the cost of rebalancing the hedging position (which is proportional to
gamma and to the volatility of the underlying asset), is an important
component of the bid and ask spread in the options market.
Direct Link: The Impact of Hedging Costs on the Bid and Ask Spread in the Options Market