Inventory Risk, Market-Maker Wealth, and the Variance Risk Premium

We investigate the role of market-makers in determining the variance risk premium. A substantial part of the variance risk premium is driven by market-makersrisk sharing capacity. When market-makers experience dramatic wealth losses, a one-standard-deviation change in inventory risk causes a 9 % change in variance risk premium. We develop a model where the market-maker is exposed to time-varying market variance through his inventory. We derive the endogenous variance risk premium and analyze its dependence on inventory risk and market-maker wealth. The model \u85ts the data well when estimated on index returns and options, particularly during the \u85nancial crisis. JEL Classi\u85cation: G10; G12; G13