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

51 Pages Posted: 3 Nov 2008

See all articles by Narayan Y. Naik

Narayan Y. Naik

London Business School - Institute of Finance and Accounting

Pradeep K. Yadav

University of Oklahoma Price College of Business

Multiple version iconThere are 3 versions of this paper

Date Written: September 2001

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 isadversely affected by their selective risk taking activity. It also investigates the efficiency of market risk sharing within a decentralized semi-transparent market structure. 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 ofregulatory distress are high, when the cost of such hedging is low, and during periods ofgreater 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 trades in the spot market are not executed by dealers with extreme exposures. In this context, we recommend market reforms such as introduction of central quote posting or limit order bookthat will enable more efficient matching of liquidity demanders and suppliers, reduce trading costs, and improve the quality of risk sharing.

Suggested Citation

Naik, Narayan Y. and Yadav, Pradeep K., Risk Management with Derivatives by Dealers and Market Quality in Government Bond Markets (September 2001). NYU Working Paper No. FIN-01-013. Available at SSRN: https://ssrn.com/abstract=1294468

Narayan Y. Naik (Contact Author)

London Business School - Institute of Finance and Accounting ( email )

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London NW1 4SA
United Kingdom
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Pradeep K. Yadav

University of Oklahoma Price College of Business ( email )

307 W.Brooks, Room 205A Division of Finance
Norman, OK 73019
United States
4053256640 (Phone)
4053255491 (Fax)

HOME PAGE: http://www.ou.edu/price/finance/faculty/pradeep_yadav.html

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