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: Suggested Citation