Risk Management with Derivatives by Dealers and Market Quality in Government Bond Markets

Authors

  • Narayan Y. Naik,

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    • *Narayan Y. Naik is from the London Business School. Pradeep K. Yadav is from Lancaster University, Lancaster, UK. Part of this work was undertaken while Pradeep Yadav was visiting the Stern School of Business of New York University and the Anderson School of Management at UCLA. We would like to thank the Bank of England for providing us with the inventory positions of government bond dealers. We are very grateful to Richard Brealey, Allison Holland, Francis Longstaff, and John Merrick for detailed discussions and an anonymous referee for many constructive suggestions. We are grateful to Viral Acharya, Vikas Agarwal, Michael Brennan, Roger Brown, Bhagwan Chowdhury, Pedro Santa-Clara, Steve Figlewski, Robert Geske, Rick Green (the editor), David Hillier, Purnendu Nath, Darius Palia, Venketesh Panchpagesan, Richard Roll, Stephen Schaefer, Eduardo Schwartz, Richard Stapleton, Raman Uppal, and seminar participants at the London Business School, University of Strathclyde, the Anderson School at UCLA, Stern School at NYU, University of Cologne, the American Finance Association Meetings 2002, the European Finance Association Meetings 2000 and the Annual Meeting of the International Association of Financial Engineers 2000, for many helpful comments and suggestions on an earlier version of this paper. We thank Purnendu Nath for excellent research assistance. Both authors are grateful to the Scottish Institute for Research in Investment and Finance (SIRIF) for infrastructural support, and the Fisher Black Memorial Foundation and the International Association of Financial Engineers for awarding an earlier version of this paper the Year 2000 Robert J. Schwartz Memorial Prize.
  • Pradeep K. Yadav

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    • *Narayan Y. Naik is from the London Business School. Pradeep K. Yadav is from Lancaster University, Lancaster, UK. Part of this work was undertaken while Pradeep Yadav was visiting the Stern School of Business of New York University and the Anderson School of Management at UCLA. We would like to thank the Bank of England for providing us with the inventory positions of government bond dealers. We are very grateful to Richard Brealey, Allison Holland, Francis Longstaff, and John Merrick for detailed discussions and an anonymous referee for many constructive suggestions. We are grateful to Viral Acharya, Vikas Agarwal, Michael Brennan, Roger Brown, Bhagwan Chowdhury, Pedro Santa-Clara, Steve Figlewski, Robert Geske, Rick Green (the editor), David Hillier, Purnendu Nath, Darius Palia, Venketesh Panchpagesan, Richard Roll, Stephen Schaefer, Eduardo Schwartz, Richard Stapleton, Raman Uppal, and seminar participants at the London Business School, University of Strathclyde, the Anderson School at UCLA, Stern School at NYU, University of Cologne, the American Finance Association Meetings 2002, the European Finance Association Meetings 2000 and the Annual Meeting of the International Association of Financial Engineers 2000, for many helpful comments and suggestions on an earlier version of this paper. We thank Purnendu Nath for excellent research assistance. Both authors are grateful to the Scottish Institute for Research in Investment and Finance (SIRIF) for infrastructural support, and the Fisher Black Memorial Foundation and the International Association of Financial Engineers for awarding an earlier version of this paper the Year 2000 Robert J. Schwartz Memorial Prize.

Abstract

This paper investigates how bond dealers manage core business risk with interest rate futures and the extent to which market quality is affected by their selective risk taking. We observe that dealers use futures to take directional bets and hedge changes in their spot exposure. We find that, cross-sectionally, a dealer with longer (shorter) risk exposure sells (buys) a larger amount of exposure the next day. However, this risk control takes place via the futures market and not the spot market. Finally, we find strong support for the price effects of capital constraints emphasized by Froot and Stein (1998).

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