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

Author

Listed:
  • Thanasis N. Christodoulopoulos

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

  • Ioulia Grigoratou

    (Bank of Greece, Monetary Policy & Banking Department)

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.

Suggested Citation

  • Thanasis N. Christodoulopoulos & Ioulia Grigoratou, 2003. "The Effect of Dynamic Hedging of Options Positions on Intermediate-Maturity Interest Rates," Working Papers 08, Bank of Greece.
  • Handle: RePEc:bog:wpaper:08
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    File URL: http://www.bankofgreece.gr/BogEkdoseis/Paper200308.pdf
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    References listed on IDEAS

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    2. Black, Fischer, 1976. "The pricing of commodity contracts," Journal of Financial Economics, Elsevier, vol. 3(1-2), pages 167-179.
    3. 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 461-472, August.
    4. Engle, Robert & Granger, Clive, 2015. "Co-integration and error correction: Representation, estimation, and testing," Applied Econometrics, Publishing House "SINERGIA PRESS", vol. 39(3), pages 106-135.
    5. Bertsimas, Dimitris & Kogan, Leonid & Lo, Andrew W., 2000. "When is time continuous?," Journal of Financial Economics, Elsevier, vol. 55(2), pages 173-204, February.
    6. 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.
    Full references (including those not matched with items on IDEAS)

    Citations

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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. 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.
    3. George A. Christodoulakis & Stephen E Satchell, 2006. "Exact Elliptical Distributions for Models of Conditionally Random Financial Volatility," Working Papers 32, Bank of Greece.
    4. Nicholas G. Zonzilos, 2004. "Econometric Modelling at the Bank of Greece," Working Papers 14, Bank of Greece.

    More about this item

    Keywords

    Interest rate options; Dynamic hedging; European yield curve;

    JEL classification:

    • E43 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Interest Rates: Determination, Term Structure, and Effects
    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G14 - Financial Economics - - General Financial Markets - - - Information and Market Efficiency; Event Studies; Insider Trading

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