The article Dealers' Hedging of Interest Rate Options in the U.S. Dollar Fixed-Income Market appears in the latest edition of the New York Fed's Economic Policy Review.
John E. Kambhu, an assistant vice president in the research group at the New York Fed, uses data from a global survey of derivatives dealers and other sources to estimate the potential impact of dynamic hedging by interest rate options dealers on the U.S. dollar fixed-income market.
Despite investors' willingness to hold a variety of financial assets and risks, a significant share of interest rate options exposures remains in the hands of dealers. This concentration of risk makes the interest rate options market an ideal place to explore the effects of dealers' hedging on underlying markets.
His study finds that:
- For short-term maturities, turnover volume in the underlying fixed-income markets is more than large enough to absorb the transaction volume generated by dealers' dynamic hedges.
- For medium-term maturities, however, an unusually large interest rate shock--on the order of 75 basis points--could lead to trading demand that is high relative to turnover volume in the more liquid trading instruments.
- Options prices appear to contain a risk premium at the medium-term segment of the yield curve, where hedging difficulties are most likely to occur. The existence of this premium suggests that liquidity risk in dynamic hedging can influence options pricing.
