Eqs. (5), (8), and (9) highlight th

Eqs. (5), (8), and (9) highlight the differences between the measures of hedging costs used in this study and those by Kaul, Nimalendran, and Zhang (2004), Petrella (2006), and Engle and Neri (2010). Our measures relate directly to the inventory holding of market makers. Most important, we break rebalancing costs into two components as shown in Eqs. (8) and (9) and disentangle the impact of these two components on option spreads. Without using inventory data, previous studies assume a single unit or a constant unit of inventory and thus cannot assess the impact of inventory changes on hedging costs and the resulting impact on option spreads. The distinction helps us to understand the importance of inventory management. If quoted spreads are more sensitive to rebalancing costs due to inventory changes than due to delta changes, market makers should be very concerned with maintaining stable inventory positions around the target levels.