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The market for sharing interest rate risk: quantities behind prices

Author

Listed:
  • Khetan, Umang

    (University of Iowa)

  • Neamțu, Ioana

    (Bank of England)

  • Sen, Ishita

    (Harvard Business School)

Abstract

We study the extent of interest rate risk sharing across the financial system. We use granular positions and transactions data in interest rate swaps, covering over 60% of overall swap activity in the world. We show that pension and insurance (PF&I) sector emerges as a natural counterparty to banks and corporations: overall, and in response to decline in rates, PF&I buy duration, whereas banks and corporations sell duration. This cross-sector netting reduces the aggregate net demand that is supplied by dealers. However, two factors impede cross-sector netting and add to dealer imbalances across maturities. (i) PF&I, bank and corporate demand is segmented across maturities. (ii) Large volumes are traded by hedge funds, who behave like banks in the short end and like PF&I in the long end. This worsens segmentation, exposing dealers to a steepening or flattening of the yield curve in addition to residual duration risk. Consistent with this, we find that demand pressure, in particular hedge funds’ trades, impact swap spreads across maturities. We also document that long-tenor pension fund trades are less likely to be centrally cleared, adding counterparty credit risk to demand imbalances.

Suggested Citation

  • Khetan, Umang & Neamțu, Ioana & Sen, Ishita, 2023. "The market for sharing interest rate risk: quantities behind prices," Bank of England working papers 1031, Bank of England.
    • Handle: RePEc:boe:boeewp:1031
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    References listed on IDEAS

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    More about this item

    Keywords

    Interest rate risk; OTC derivatives; hedge funds; pension funds; insurance companies; banks; non-financial corporations; demand elasticities; counterparty credit risk;
    All these keywords.

    JEL classification:

    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G15 - Financial Economics - - General Financial Markets - - - International Financial Markets
    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
    • G22 - Financial Economics - - Financial Institutions and Services - - - Insurance; Insurance Companies; Actuarial Studies
    • G23 - Financial Economics - - Financial Institutions and Services - - - Non-bank Financial Institutions; Financial Instruments; Institutional Investors
    • G24 - Financial Economics - - Financial Institutions and Services - - - Investment Banking; Venture Capital; Brokerage
    • G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill

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