How Do Dealers in Government Bond Markets Manage Their Spot Risk with Derivatives? Evidence from London

53 Pages Posted: 10 Apr 2000

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

Date Written: September 12, 2000

Abstract

Using a comprehensive data-set from the Bank of England containing the close-of-business positions of individual UK government bond dealers in each bond issue and in all related futures contracts, we examine how the dealers use futures markets to manage the risk of their spot portfolio. We find that the size of dealers' positions in futures contracts is comparable in magnitude to their positions in the spot market, and that the dealers take on significant directional risks often by holding futures that are in the same direction as the spot. Although, in general, the dealers do not seem to use futures to reduce the level of their spot risk, we so find that they actively use futures to offset the changes in the levels of their spot risk. However, this offset is partial in most cases. They use futures to offset changes in their spot exposure to a greater extent when the bonds they hold in their portfolio are more efficiently hedgeable with futures contracts, and on days when the cost of offsetting (as measured by the predictable change in futures mispricing) is lower. They also offset more when the level of their spot risk is high and when recent changes in the spot risk are in a direction that exacerbates their spot risk exposure (i.e., when the potential costs of regulatory distress are high). Finally, we observe that dealers offset changes in their spot exposure to a greater extent immediately prior to important macroeconomic announcements and to a lesser extent immediately thereafter.

Note: Previously titled, "Do Market Intermediaries Hedge their Risk Exposure with Derivatives? Evidence from the UK Govt Bond Dealers' Spot & Derivatives Positions"

JEL Classification: G10, G20, G24

Suggested Citation

Naik, Narayan Y. and Yadav, Pradeep K., How Do Dealers in Government Bond Markets Manage Their Spot Risk with Derivatives? Evidence from London (September 12, 2000). AFA 2002 Atlanta Meetings; IFA Working Paper No. 301. Available at SSRN: https://ssrn.com/abstract=214609 or http://dx.doi.org/10.2139/ssrn.214609

Narayan Y. Naik (Contact Author)

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

Sussex Place
Regent's Park
London NW1 4SA
United Kingdom
+44 20 7262 5050 (Phone)
+44 20 724 3317 (Fax)

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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