A study forthcoming in the Federal Reserve Bank of New York’s Economic Policy Review discusses the stabilizing role of trading activity in markets and the effects of trading risk on market stability.
In Trading Risk, Market Liquidity, and Convergence Trading in the Interest Rate Swap Spread, economist John Kambhu considers how the risk in convergence trading affects market liquidity and asset price volatility by examining the behavior of the interest rate swap spread and the volume of repo contracts. Convergence trading is the practice in which speculators trade on the expectation that asset prices will converge to normal, or fundamental, levels, typically moving prices toward these levels and thus stabilizing markets.
Kambhu finds both stabilizing and destabilizing forces attributable to leveraged trading activity. He argues that by countering and smoothing price shocks, the trading flows of convergence traders can enhance market liquidity. The swap spread tends to converge to its fundamental level more slowly when traders are weakened by losses, while higher trading risk can cause the spread to diverge from that level. However, if convergence trades are closed out prematurely, asset prices tend to diverge further from their fundamental values, rather than converge.
John Kambhu is a vice president at the Federal Reserve Bank of New York.