Staff Reports
Intraday Market Making with Overnight Inventory Costs
October 2016 Number 799
Revised March 2020
JEL classification: G12, G17, G23

Authors: Tobias Adrian, Agostino Capponi, Michael Fleming, Erik Vogt, and Hongzhong Zhang

The U.S. Treasury market is highly intermediated by nonbank principal trading firms (PTFs). Limited capital forces PTFs to end the trading day roughly flat. We construct a continuous time market making model to analyze the trade-off faced by a profit-maximizing firm with overnight inventory costs, and develop closed-form representations of the optimal price policy functions. Our model reveals that bid-ask spreads widen as the end of the trading day approaches, and that increases in order arrival rates do not always lead to higher price volatility. Our empirical analysis shows that Treasury security trading costs increase as the close of trading approaches, consistent with model predictions.

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