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Dealers' hedging of interest rate options in the U.S. dollar fixed-income market

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  • John Kambhu

Abstract

Despite investors' willingness to hold a variety of financial assets and risks, a significant share of interest rate options exposures remains in the hands of dealers. This concentration of risk makes the interest rate options market an ideal place to explore the effects of dealers' dynamic hedging on underlying markets. Using data from a global survey of derivatives dealers and other sources, this article estimates the potential impact of dynamic hedging by interest rate options dealers on the fixed-income market. The author finds that for short-term maturities, turnover volume in the most liquid hedging instruments is more than large enough to absorb dealers' dynamic hedges. For medium-term maturities, however, an unusually large interest rate shock could lead to hedging difficulties.

Suggested Citation

  • John Kambhu, 1998. "Dealers' hedging of interest rate options in the U.S. dollar fixed-income market," Economic Policy Review, Federal Reserve Bank of New York, issue Jun, pages 35-58.
  • Handle: RePEc:fip:fednep:y:1998:i:jun:p:35-58:n:v.4no.2
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    References listed on IDEAS

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    1. De Long, J Bradford, et al, 1990. " Positive Feedback Investment Strategies and Destabilizing Rational Speculation," Journal of Finance, American Finance Association, vol. 45(2), pages 379-395, June.
    2. Gennotte, Gerard & Leland, Hayne, 1990. "Market Liquidity, Hedging, and Crashes," American Economic Review, American Economic Association, vol. 80(5), pages 999-1021, December.
    3. Grossman, Sanford J, 1988. "An Analysis of the Implications for Stock and Futures Price Volatility of Program Trading and Dynamic Hedging Strategies," The Journal of Business, University of Chicago Press, vol. 61(3), pages 275-298, July.
    4. Julia Fernald & Patricia C. Mosser & Frank Keane, 1994. "Mortgage security hedging and the yield curve," Quarterly Review, Federal Reserve Bank of New York, issue Sum, pages 92-100.
    5. Michael J. Fleming, 1997. "The round-the-clock market for U.S. Treasury securities," Economic Policy Review, Federal Reserve Bank of New York, issue Jul, pages 9-32.
    6. Bernanke, Ben S, 1990. "Clearing and Settlement during the Crash," Review of Financial Studies, Society for Financial Studies, vol. 3(1), pages 133-151.
    7. Lisa N. Galaif, 1993. "Index amortizing rate swaps," Quarterly Review, Federal Reserve Bank of New York, issue Win, pages 63-70.
    8. John Kambhu & Frank M. Keane & Catherine Benadon, 1996. "Price risk intermediation in the over-the-counter derivatives markets: interpretation of a global survey," Economic Policy Review, Federal Reserve Bank of New York, issue Apr, pages 1-15.
    9. Jameson, Mel & Wilhelm, William, 1992. " Market Making in the Options Markets and the Costs of Discrete Hedge Rebalancing," Journal of Finance, American Finance Association, vol. 47(2), pages 765-779, June.
    10. Julia Fernald & Patricia C. Mosser & Frank Keane, 1994. "Mortgage security hedging and the yield curve," Research Paper 9411, Federal Reserve Bank of New York.
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    Cited by:

    1. Michael S. Gibson & Matthew Pritsker, 2000. "Improving grid-based methods for estimating value at risk of fixed-income portfolios," Finance and Economics Discussion Series 2000-25, Board of Governors of the Federal Reserve System (U.S.).
    2. Graveline, Jeremy J. & McBrady, Matthew R., 2011. "Who makes on-the-run Treasuries special?," Journal of Financial Intermediation, Elsevier, vol. 20(4), pages 620-632, October.

    More about this item

    Keywords

    Hedging (Finance) ; Options (Finance);

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