Hedging-Induced Correlation in Illiquid Markets

53 Pages Posted: 8 Jun 2020 Last revised: 11 Jun 2020

Date Written: May 12, 2020


I develop a model with two assets in which the hedging activity of derivatives dealers, interacting with market illiquidity, distorts the covariance structure of the market. I apply the model to hedging of counter party risk, and find strong support for the model's key predictions. Using evidence from Japan, I show that hedging of counterparty risk associated with currency swap portfolios drives a strong, non-fundamental correlation between credit and currency markets. The effects are economically significant. For example, I estimate that counter party risk hedging associated with SoftBank's FX swap portfolio accounts for 25% of the weekly volatility of SoftBank CDS returns.

Keywords: OTC Derivatives, Hedging, Limits-to-Arbitrage, Cross-Asset Correlation, Credit Default Swaps, Counter Party Risk

JEL Classification: G13, G14, G18

Suggested Citation

Brøgger, Søren Bundgaard, Hedging-Induced Correlation in Illiquid Markets (May 12, 2020). Available at SSRN: https://ssrn.com/abstract=3599477 or http://dx.doi.org/10.2139/ssrn.3599477

Søren Bundgaard Brøgger (Contact Author)

Copenhagen Business School ( email )

Solbjerg Plads 3
Frederiksberg C, DK - 2000

HOME PAGE: http://https://sites.google.com/view/soerenbroegger

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