Risk management with derivatives by dealers and market quality in government bond markets
Subject
Finance, Finance
Publishing details
Authors / Editors
Naik N Y; Yadav P K
Biographies
Publication Year
2001
Abstract
This paper examines how bond dealers use futures markets to manage the hedgeable market risk component of their core business risk exposure, and whether market quality is adversely affected by their selective risk taking activity. It also investigates the efficiency of market risk sharing within a decentralized semi-transparent market structure. We find that dealers engage in duration targeting, behaving as if they have a comparative advantage in bearing interest rate risk. They make significant directional bets often by holding futures that are in the same direction as the spot. They actively use futures to hedge changes in the spot exposure. They hedge changes in their spot exposure more when the potential costs of regulatory distress are high, when the cost of such hedging is low, and during periods of greater uncertainty. We find that duration targeting by dealers has adverse price effects due to capital constraints as predicted by Froot and Stein (1998). Finally, we find that trades in the spot market are not executed by dealers with extreme exposures. In this context, we recommend market reforms such as introduction of central quote posting or limit order book that will enable more efficient matching of liquidity demanders and suppliers, reduce trading costs, and improve the quality of risk sharing.
Publication Research Centre
Institute of Finance and Accounting, Institute of Finance and Accounting
Series Number
FIN 338
Series
IFA Working Paper