Money Market Derivatives and the Allocation of Liquidity Risk in the Banking Sector

30 Pages Posted: 12 Jun 2006

See all articles by Hendrik Hakenes

Hendrik Hakenes

Finance Group; Centre for Economic Policy Research (CEPR)

Falko Fecht

Frankfurt School of Finance & Management

Date Written: June 2006

Abstract

Money markets have two functions, the allocation of liquidity and the processing of information. We develop a model that allows us to evaluate the efficiency of different money market derivatives regarding these two objectives. We assume that due to its size, a large bank receives a more precise signal about the overall liquidity development in the banking sector. In an upcoming liquidity shortage this large bank can exploit its informational advantage in the spot money market by rationing liquidity. Using forward contracts, the large bank can credibly commit not to squeeze small banks in the event of a liquidity shortage. But forward contracts do not provide incentives for the large bank to pass on its information to other banks. In contrast, lines of credit between the large and the small banks ensure that the large bank provides its information to other banks.

Keywords: Liquidity, money market derivatives, lines of credit, forward contracts, options

JEL Classification: G21, G33, D82

Suggested Citation

Hakenes, Hendrik and Fecht, Falko, Money Market Derivatives and the Allocation of Liquidity Risk in the Banking Sector (June 2006). EFA 2006 Zurich Meetings. Available at SSRN: https://ssrn.com/abstract=908184 or http://dx.doi.org/10.2139/ssrn.908184

Hendrik Hakenes (Contact Author)

Finance Group ( email )

Adenauerallee 24-42
D-53113 Bonn
Germany
+49-228-73-9225 (Phone)

HOME PAGE: http://www.finance.uni-bonn.de/hakenes

Centre for Economic Policy Research (CEPR) ( email )

London
United Kingdom

Falko Fecht

Frankfurt School of Finance & Management ( email )

Adickesallee 32-34
Frankfurt am Main, 60322
Germany

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