Inventory Risk, Market-Maker Wealth, and the Variance Risk Premium: Theory and Evidence
Mathieu Fournier; HEC Montréal
Kris Jacobs; University of Houston
March 13, 2015
Abstract
We investigate the role of option market-makers in determining the variance risk premium.A substantial part of the variance risk premium is driven by market-makers risk sharing capacity. When market-makers experience dramatic wealth losses, a one-standard-deviation change in inventory risk leads to more than 9% change in the variance risk premium. Motivated by our
findings, we develop a model in which a market-maker with limited capital is exposed to market variance risk through inventory. We derive an endogenous variance risk premium and analyze its dependence on inventory risk and market-maker wealth. Estimating the model on index returns and options we
nd that it
ts the data well speci
fically during the
financial crisis.
JEL Classi
cation: G10; G12; G13.
Keywords: Variance risk premium; inventory risk; financial constraints; option pricing.
