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

  • John Kambhu
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    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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    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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    1. Bank for International Settlements, 1998. "Report on OTC Derivatives: Settlement procedures and counterparty risk management," CGFS Papers, Bank for International Settlements, number 08, Autumn.
    2. Andrei Shleifer ad Robert W. Vishny, 1995. "The Limits of Arbitrage," Harvard Institute of Economic Research Working Papers 1725, Harvard - Institute of Economic Research.
    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. 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.
    5. 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.
    6. 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.
    7. 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).
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