FIN-01-013 |
NYU Stern School of Business |
Risk Management with Derivatives by Dealers and Market Quality in Government Bond Markets
September 21, 2001
Narayan Y. Naik and Pradeep K. Yadav
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.
Classification: G10, G20, G24
Narayan Y. Naik
Institution: London Business School, UK
Telephone: +44 207 2625050
Fax: 212-995-4233
Email: nnaik@london.edu
Home Page: http://www.london.edu/faculty_research/
Pradeep K. Yadav
Institution: Leonard N. Stern School of Business, New York University
Telephone: 212-998-0305
Fax: 212-995-4233
Email: pyadav@stern.nyu.edu
Home Page: http://www.stern.nyu.edu/~pyadav
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