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Y2K options and the liquidity premium in Treasury bond markets

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  • Suresh Sundaresan
  • Zhenyu Wang

Abstract

Financial institutions around the world expected the millennium date change (Y2K) to cause an aggregate liquidity shortage. Responding to concerns about this liquidity shortage, the Federal Reserve Bank of New York auctioned Y2K options to primary dealers. The options gave the dealers the right to borrow from the Fed at a predetermined interest rate. The implied volatilities of Y2K options and the aggressiveness of demand for these instruments reveal that the Fed's action eased the fears of bond dealers, contributing to a drop in the liquidity premium of Treasury securities. Our analysis shows the link between the microstructure of government debt prices and the central bank's provision of liquidity. The use of Y2K options and their effect on the liquidity premium broadly conform to the economic theory and practice of the public provision of private liquidity.

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Bibliographic Info

Paper provided by Federal Reserve Bank of New York in its series Staff Reports with number 266.

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Date of creation: 2006
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Handle: RePEc:fip:fednsr:266

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Keywords: Options (Finance) ; Liquidity (Economics) ; Federal Reserve Bank of New York ; Government securities;

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References

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  1. Evangeline Sophia Drossos & Spence Hilton, 2000. "The Federal Reserve's contingency financing plan for the century date change," Current Issues in Economics and Finance, Federal Reserve Bank of New York, vol. 6(Dec).
  2. Newey, Whitney & West, Kenneth, 2014. "A simple, positive semi-definite, heteroscedasticity and autocorrelation consistent covariance matrix," Applied Econometrics, Publishing House "SINERGIA PRESS", vol. 33(1), pages 125-132.
  3. Holmstrom, B & Tirole, J, 1996. "Private and Public Supply of Liquidity," Working papers 96-21, Massachusetts Institute of Technology (MIT), Department of Economics.
  4. Kamara, Avraham, 1994. "Liquidity, Taxes, and Short-Term Treasury Yields," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 29(03), pages 403-417, September.
  5. Michael J. Fleming, 2003. "Measuring treasury market liquidity," Economic Policy Review, Federal Reserve Bank of New York, issue Sep, pages 83-108.
  6. White, Halbert, 1980. "A Heteroskedasticity-Consistent Covariance Matrix Estimator and a Direct Test for Heteroskedasticity," Econometrica, Econometric Society, vol. 48(4), pages 817-38, May.
  7. Holmstrom, Bengt & Tirole, Jean, 1996. "Modeling Aggregate Liquidity," American Economic Review, American Economic Association, vol. 86(2), pages 187-91, May.
  8. Musto, David K, 1997. " Portfolio Disclosures and Year-End Price Shifts," Journal of Finance, American Finance Association, vol. 52(4), pages 1563-88, September.
  9. Duffie, Darrell, 1996. " Special Repo Rates," Journal of Finance, American Finance Association, vol. 51(2), pages 493-526, June.
  10. Woodford, Michael, 1990. "Public Debt as Private Liquidity," American Economic Review, American Economic Association, vol. 80(2), pages 382-88, May.
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Cited by:
  1. Feldh├╝tter, Peter & Lando, David, 2008. "Decomposing swap spreads," Journal of Financial Economics, Elsevier, vol. 88(2), pages 375-405, May.
  2. James McAndrews & Asani Sarkar & Zhenyu Wang, 2008. "The effect of the Term Auction Facility on the London Inter-Bank Offered Rate," Staff Reports 335, Federal Reserve Bank of New York.
  3. Arvind Krishnamurthy & Annette Vissing-Jorgensen, 2007. "The Demand for Treasury Debt," NBER Working Papers 12881, National Bureau of Economic Research, Inc.
  4. Jennifer Huang & Jiang Wang, 2008. "Market Liquidity, Asset Prices and Welfare," NBER Working Papers 14058, National Bureau of Economic Research, Inc.
  5. Pasquariello, Paolo & Vega, Clara, 2009. "The on-the-run liquidity phenomenon," Journal of Financial Economics, Elsevier, vol. 92(1), pages 1-24, April.

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