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Journal Article
Correlation products and risk management issues
Unlike standard derivatives instruments, correlation products contain nonseparable risk, meaning that the price sensitivity of one risk factor is a function of the level of another risk factor. This article outlines the pricing and hedging of one type of correlation product, the differential swap, to show how nonseparable risk may escape traditional methods of assessing the risk of institutions' portfolios. The article considers the implications of correlation products for supervisory and institutional practices and concludes with a brief discussion of some ways nonseparable risk may be ...
Journal Article
Dealers' hedging of interest rate options in the U.S. dollar fixed-income market
Despite investors' willingness to hold a variety of financial assets and risks, a significant share of interest rate options exposures remains in the hands of dealers. This concentration of risk makes the interest rate options market an ideal place to explore the effects of dealers' dynamic hedging on underlying markets. Using data from a global survey of derivatives dealers and other sources, this article estimates the potential impact of dynamic hedging by interest rate options dealers on the fixed-income market. The author finds that for short-term maturities, turnover volume in the most ...
Journal Article
The effect of interest rate options hedging on term-structure dynamics
Market participants and policymakers closely monitor movements in the yield curve for information about future economic fundamentals. In several recent episodes, however, disruptions to market liquidity have affected the short-term dynamics of the curve independently of fundamentals. This article provides evidence that the short-run dynamics in the intermediate maturities of the yield curve changed around 1990, with the appearance of positive feedback in weekly interest rate changes. The feedback is consistent with the effects of options dealers? hedging activity and it is found only in the ...
Report
An analysis of OTC interest rate derivatives transactions: implications for public reporting
This paper examines the over-the-counter (OTC) interest rate derivatives (IRD) market in order to inform the design of post-trade price reporting. Our analysis uses a novel transaction-level data set to examine trading activity, the composition of market participants, levels of product standardization, and market-making behavior. We find that trading activity in the IRD market is dispersed across a broad array of product types, currency denominations, and maturities, leading to more than 10,500 observed unique product combinations. While a select group of standard instruments trade with ...
Report
Securities lending
This paper, originally released in August 1989 as part of a Federal Reserve Bank of New York series on the U.S. securities markets, examines loans of Treasury and agency securities in the domestic market. It highlights some important institutional characteristics of securities loan transactions, in particular the common use of agents to arrange the terms of the loans. While we note that this characteristic sets securities lending apart from most repurchase agreement (repo) transactions, which occur bilaterally between a borrower and a lender, we observe that repo and securities loan ...
Report
Traders' broker choice, market liquidity and market structure
Hedgers and a risk-neutral informed trader choose between a broker who takes a position in the asset (a capital broker) and a broker who does not (a discount broker). The capital broker exploits order flow information to mimic informed trades and offset hedgers' trades, reducing informed profits and hedgers' utility. But the capital broker has a larger capacity to execute hedgers' orders, increasing market depth. In equilibrium, hedgers choose the broker with the lowest price per unit of utility while the informed trader chooses the broker with the lowest price per unit of the informed order ...
Journal Article
The pricing and hedging of market index deposits
Journal Article
Mortgage security hedging and the yield curve
The authors find that the use of Treasury securities to hedge mortgage-backed security extension risk may have magnified increases in long-term interest rates after the tightening of monetary policy in early 1994. Substantial increases in the duration of mortgage securities appear to have caused realignments of hedges and portfolios that, in turn, had a significant impact on the short-run movements of the Treasury market, particularly for ten-year securities. This phenomenon may have altered the short-run dynamics of the yield curve and thus changed the transmission of monetary policy.
Report
Market liquidity and trader welfare in multiple dealer markets: evidence from dual trading restrictions
Dual trading is the practice whereby futures floor traders execute trades both for their own and customers' accounts on the same day. We provide evidence, in the context of restrictions on dual trading, that aggregate liquidity measures, such as the average bid-ask spread, may be misleading indicators of traders' welfare in markets with multiple, heterogeneously skilled dealers. In our theoretical model, hedgers and informed customers trade through futures floor traders of different skill levels: more skilled floor traders attract more hedgers to trade. We show that customers' welfare and ...
Report
Interest rate options dealers' hedging in the US dollar fixed income market
The potential for the dynamic hedging of written options to lead to positive feedback in asset price dynamics has received repeated attention in the literature on financial derivatives. Using data on OTC interest rate options from a recent survey of global derivatives markets, this paper addresses the question whether that potential for positive feedback is likely to be realized. With the possible exception of the medium term segment of the term structure, transaction volume in available hedging instruments is sufficiently large to absorb the demands resulting from the dynamic hedging of US ...