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Trading risk, market liquidity, and convergence trading in the interest rate swap spread

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  • John Kambhu
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    Abstract

    While trading activity is generally thought to play a central role in the self-stabilizing behavior of markets, the risks in trading on occasion can affect market liquidity and heighten asset price volatility. This article examines empirical evidence on the limits of arbitrage in the interest rate swap market. The author finds both stabilizing and destabilizing forces attributable to leveraged trading activity. Although the swap spread tends to converge to its fundamental level, it does so more slowly or even diverges from its fundamental level when traders are under stress, as indicated by shocks in hedge fund earnings and the volume of repo contracts. In addition, repo volume falls when convergence trading risk is higher, and reflects shocks that destabilize the swap spread. The behavior of repo volume in particular points to how trading risk affects market liquidity and asset price volatility.

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    Bibliographic Info

    Article provided by Federal Reserve Bank of New York in its journal Economic Policy Review.

    Volume (Year): (2006)
    Issue (Month): May ()
    Pages: 1-13

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    Handle: RePEc:fip:fednep:y:2006:i:may:p:1-13:n:v.12no.1

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    Keywords: Liquidity (Economics) ; Risk ; Swaps (Finance) ; Arbitrage ; Asset pricing ; Repurchase agreements;

    References

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    1. Andrei Shleifer ad Robert W. Vishny, 1995. "The Limits of Arbitrage," Harvard Institute of Economic Research Working Papers 1725, Harvard - Institute of Economic Research.
    2. Bank for International Settlements, 1998. "Report on OTC Derivatives: Settlement procedures and counterparty risk management," CGFS Papers, Bank for International Settlements, number 08, July.
    3. Duffie, Darrell & Singleton, Kenneth J, 1997. " An Econometric Model of the Term Structure of Interest-Rate Swap Yields," Journal of Finance, American Finance Association, vol. 52(4), pages 1287-1321, September.
    4. Pierre Collin-Dufresne, 2001. "On the Term Structure of Default Premia in the Swap and LIBOR Markets," Journal of Finance, American Finance Association, vol. 56(3), pages 1095-1115, 06.
    5. Jun Liu & Francis A. Longstaff & Ravit E. Mandell, 2002. "The Market Price of Credit Risk: An Empirical Analysis of Interest Rate Swap Spreads," NBER Working Papers 8990, National Bureau of Economic Research, Inc.
    6. Tobias Adrian & Michael J. Fleming, 2005. "What financing data reveal about dealer leverage," Current Issues in Economics and Finance, Federal Reserve Bank of New York, vol. 11(Mar).
    7. Xiong, Wei, 2001. "Convergence trading with wealth effects: an amplification mechanism in financial markets," Journal of Financial Economics, Elsevier, vol. 62(2), pages 247-292, November.
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    Cited by:
    1. Nicole M. Boyson & Christof W. Stahel & René M. Stulz, 2010. "Hedge Fund Contagion and Liquidity Shocks," Journal of Finance, American Finance Association, vol. 65(5), pages 1789-1816, October.
    2. Tobias Adrian & Hyun Song Shin, 2008. "Liquidity and leverage," Staff Reports 328, Federal Reserve Bank of New York.
    3. Boyson, Nicole M. & Stahel, Christof W. & Stulz, Rene M., 2011. "Liquidity Shocks and Hedge Fund Contagion," Working Paper Series 2011-12, Ohio State University, Charles A. Dice Center for Research in Financial Economics.
    4. Boyson, Nicole M. & Stahel, Christof W. & Stulz, Rene, 2008. "Hedge Fund Contagion and Liquidity," Working Paper Series 2008-8, Ohio State University, Charles A. Dice Center for Research in Financial Economics.
    5. John Kambhu & Til Schuermann & Kevin J. Stiroh, 2007. "Hedge funds, financial intermediation, and systemic risk," Economic Policy Review, Federal Reserve Bank of New York, issue Dec, pages 1-18.
    6. Chung, Hon-Lun & Chan, Wai-Sum, 2010. "Impact of credit spreads, monetary policy and convergence trading on swap spreads," International Review of Financial Analysis, Elsevier, vol. 19(2), pages 118-126, March.

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