In the Context of Derivatives, What Is the ‘Inventory Risk’ for a Market Maker?

Inventory risk is the risk that the market maker's net position (their 'inventory') in the underlying asset or the derivative itself will lose value due to adverse price movements. When a market maker facilitates a trade, they take on a temporary or permanent inventory position that must be managed, typically through hedging.

The risk is higher for illiquid assets where the position is harder to quickly offload.