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Dealers make money by providing liquidity to clients but face flowuncertainty and thus price risk. They can efficiently skew their prices andwait for clients to mitigate risk (internalization), or trade with otherdealers in the open market to hedge their position and reduce their inventory(externalization). Of course, the better control associated withexternalization comes with transaction costs and market impact. Theinternalization vs. externalization dilemma has been a topic of recent activediscussion within the foreign exchange (FX) community. This paper offers anoptimal control framework for market making tackling both pricing and hedging,thus answering a question well known to dealers: `to hedge, or not to hedge?'

Market making by an FX dealer: tiers, pricing ladders and hedging rates for optimal risk control