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Please use this identifier to cite or link to this item:
http://hdl.handle.net/2451/26540
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| Title: | Risk Management with Derivatives by Dealers and Market Quality in
Government Bond Markets |
| Authors: | Naik, Narayan Y.
Yadav, Pradeep K. |
| Issue Date: | 21-Sep-2001 |
| Series/Report no.: | FIN-01-013 |
| 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. |
| URI: | http://hdl.handle.net/2451/26540 |
| Appears in Collections: | Finance Working Papers
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