Dealers' Hedging of Interest Rate Options in the U.S. Dollar Fixed-Income Market

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.

Keywords: interest rate options

JEL Classification: G10, G13, G24