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The Effect of Dynamic Hedging of Options Positions on Intermediate-Maturity Interest Rates

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Author Info

  • Thanasis N. Christodoulopoulos

    ()
    (Bank of Greece, Monetary Policy & Banking Department)

  • Ioulia Grigoratou

    (Bank of Greece, Monetary Policy & Banking Department)

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    Abstract

    When interest rates change, interest rate options dealers buy or sell securities to adjust the hedging positions that they have taken in order to offset their options exposures. The net result of this trading activity, which is unrelated to economic fundamentals, can be to push interest rates further in the direction they were moving. Such “feedback” effects interfere with the short-term dynamics of interest rate movements and can alter the shape of the yield curve, especially when changes in interest rates are large. Our empirical results confirm the existence of a positive feedback from the activity in the euro-denominated interest rate options market to the european yield curve. This finding can be useful for risk management purposes but also for analysts and policy makers when interpreting short-run movements in the yield curve as signals of future economic activity.

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    File URL: http://www.bankofgreece.gr/BogEkdoseis/Paper200308.pdf
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    Bibliographic Info

    Paper provided by Bank of Greece in its series Working Papers with number 08.

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    Length: 32 pages
    Date of creation: Dec 2003
    Date of revision:
    Handle: RePEc:bog:wpaper:08

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    Web page: http://www.bankofgreece.gr
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    Related research

    Keywords: Interest rate options; Dynamic hedging; European yield curve;

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    References

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    1. Osterwald-Lenum, Michael, 1992. "A Note with Quantiles of the Asymptotic Distribution of the Maximum Likelihood Cointegration Rank Test Statistics," Oxford Bulletin of Economics and Statistics, Department of Economics, University of Oxford, vol. 54(3), pages 461-72, August.
    2. Dickey, David A & Fuller, Wayne A, 1981. "Likelihood Ratio Statistics for Autoregressive Time Series with a Unit Root," Econometrica, Econometric Society, vol. 49(4), pages 1057-72, June.
    3. Engle, Robert F & Granger, Clive W J, 1987. "Co-integration and Error Correction: Representation, Estimation, and Testing," Econometrica, Econometric Society, vol. 55(2), pages 251-76, March.
    4. Clewlow, Les & Hodges, Stewart, 1997. "Optimal delta-hedging under transactions costs," Journal of Economic Dynamics and Control, Elsevier, vol. 21(8-9), pages 1353-1376, June.
    5. Black, Fischer, 1976. "The pricing of commodity contracts," Journal of Financial Economics, Elsevier, vol. 3(1-2), pages 167-179.
    6. Bertsimas, Dimitris & Kogan, Leonid & Lo, Andrew W., 2000. "When is time continuous?," Journal of Financial Economics, Elsevier, vol. 55(2), pages 173-204, February.
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    Cited by:
    1. Eleni Angelopoulou, 2005. "The Comparative Performance of Q-type and Dynamic Models of Firm Investment: Empirical Evidence from the UK," Working Papers 27, Bank of Greece.
    2. Nicholas G. Zonzilos, 2004. "Econometric Modelling at the Bank of Greece," Working Papers 14, Bank of Greece.
    3. Sideris, Dimitrios, 2006. "Testing for long-run PPP in a system context: Evidence for the US, Germany and Japan," Journal of International Financial Markets, Institutions and Money, Elsevier, vol. 16(2), pages 143-154, April.
    4. George A. Christodoulakis & Stephen E Satchell, 2006. "Exact Elliptical Distributions for Models of Conditionally Random Financial Volatility," Working Papers 32, Bank of Greece.

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