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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.|
|Appears in Collections:||Finance Working Papers|
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