Price Risk Intermediation in the Over-the-Counter Derivatives Markets: Interpretation of a Global Survey
Kambhu, John, Keane, Frank, Benadon, Catherine, Federal Reserve Bank of New York Economic Policy Review
Since the early 1980s, the financial derivatives markets have increasingly been used by market participants to unbundle and trade their exposures to foreign exchange rate risk, interest rate risk, and other types of price risk.(1) The markets have given firms that wish to shed unwanted price risk the ability to hedge their exposures at low cost while offering investors flexibility in structuring their trading and investment positions.
Derivatives contracts are especially efficient vehicles for unbundling the price risks embodied in assets and liabilities.(2) The contracts allow users to trade away the risks they do not wish to be exposed to while retaining other risk exposures. For example, in a financing relationship between a lender and borrower, an interest rate swap can be used to strip out the interest rate risk from the credit risk. Such an unbundling of risk can resolve differences in the risk preferences of the lender and borrower by passing the unwanted interest rate risk to others in the derivatives markets who are more willing to bear it.
Drawing on the results of a recent central bank survey of these markets, this article looks to answer questions about the role of derivatives markets in the intermediation of price risks--specifically, their role in the transfer and trading of price risk exposures in the financial system. For example, what is the scale of potential price and credit shocks that could be transmitted through the derivatives markets? Are the price risk exposures traded by the endorsers of derivatives concentrated among derivatives dealers? What is the relationship between the over-the-counter and the exchange-traded derivatives markets?
THE CENTRAL BANK SURVEY OF DERIVATIVES MARKET ACTIVITY
To provide interested parties with consistent and comprehensive data about the size and structure of the financial derivatives markets, in April 1995 central banks in twenty-six countries conducted the "Central Bank Survey of Derivatives Market Activity." The Bank for International Settlements (BIS) coordinated the survey and aggregated the national survey data to produce global market statistics.(3) One of the most important contributions of the survey was the collection of global data on market values of derivatives contracts. These data, broken down by counterparty type and desegregated by contracts with positive and negative values (from the perspective of reporting dealers), provided a unique view of the derivatives markets' intermediation of price risks.
Data were collected from banks and securities firms that trade in the over-the-counter derivatives markets. The reporting panel consisted of more than 2,000 reporters in twenty-six countries. However, most reporters were the local trading desks of large, internationally active parent companies. (Most parent companies had trading desks in many of the twenty-six countries.) The U.S. portion of the survey had fifty-one reporters with both domestic and foreign parents. The reporting panel in the United States was restricted to derivatives dealers, and affiliates of these firms were also reporters in other countries. The aggregation of market totals in the survey used an adjustment to avoid the double counting of transactions between reporters, both at the national and at the crossiborder level.
The survey collected data on new transactions (turnover) during April 1995 and outstanding contracts at the end of March 1995 in terms of activity. in each participating country. Outstanding contracts were reported on the basis of contracts booked in each country (book location), and turnover data were reported on the basis of new ion). The transactions executed in each country (trade local U.S. portion of the survey, for example, collected data on outstanding contracts booked in the United States and new transactions executed there.
The survey data were broken down by counter-party type and product category. Reporters were asked to assign all their derivatives contracts to the product categories used in the survey (Table 1). …