Pre-hedging

This paper studies a dealer that pre-hedges an anticipated potential trade, and we analyze how this affects the client’s overall execution outcome. We show that pre-hedging can benefit both parties: Improved risk management over an extended horizon enables the dealer to charge reduced spreads that more than offset any adverse impact the pre-hedging activity has on the execution price. However, when a dealer pre-hedges too aggressively, this can be detrimental to the client. Timing uncertainty of the potential trade is an effective control held by the client to mitigate any counterproductive pre-hedging. Our results are robust to a setting where competing dealers simultaneously pre-hedge.

Supplemental Material: All supplemental materials, including the code, data, and files required to reproduce the results, are available at https://doi.org/10.1287/opre.2024.1011.