Risk Management with Derivatives by Dealers and Market Quality in Government Bond Markets

Abstract:     
This paper examines how bond dealers use futures markets to manage the hedgeable market risk component of their core business risk exposure, and whether market quality is adversely affected by their selective risk taking activity. It also investigates risk sharing among bond dealers in the presence of the futures market. We find that dealers engage in duration targeting, behaving as if they have a comparative advantage in bearing interest rate risk. They make significant directional bets often by holding futures that are in the same direction as the spot. They actively use futures to hedge changes in the spot exposure. They hedge changes in their spot exposure more when the potential costs of regulatory distress are high, when the cost of such hedging is low, and during periods of greater uncertainty. We find that duration targeting by dealers has adverse price effects due to capital constraints as predicted by Froot and Stein (1998). Finally, we find that risk-reduction is undertaken entirely through futures, which implies that spot-market trades are not executed by dealers with extreme exposures. This has important implications for regulators. While a well-functioning bond futures market is a useful risk management tool for all market participants, it also reduces incentives for bond dealers to offer price improvement to move their own spot market inventory, thereby potentially increasing inside spreads, unless the spot market trading structure can be reformed to directly achieve a better matching between public investors and dealers with divergent exposure through, for example, high pre-trade transparency.

Number of Pages in PDF File: 51

JEL Classification: G10, G20, G24

working papers series