The Effect of Interest Rate Options Hedging on Term-Structure Dynamics

By Kambhu, John; Mosser, Patricia C. | Federal Reserve Bank of New York Economic Policy Review, December 2001 | Go to article overview

The Effect of Interest Rate Options Hedging on Term-Structure Dynamics


Kambhu, John, Mosser, Patricia C., Federal Reserve Bank of New York Economic Policy Review


* Beginning in the 1990s, the short-term dynamics of the yield curve changed in ways that appear to be related to the growth of the interest rate options market.

* When interest rates change, options dealers buy or sell securities to adjust the hedging positions that they have taken to offset their options exposures. Since the early 1990s, these trades have been, in aggregate, large enough to affect market liquidity.

* The net result of this trading activity can be to push interest rates further in the direction they were moving. Such "feedback" effects can alter the shape of the yield curve, especially when changes in interest rates are large.

* For this reason, analysts should use caution in interpreting short-run movements in the yield curve as signals of future economic developments.

Research has shown that the yield curve is a reasonably good predictor of economic activity, in part because it seems to reflect expectations of future economic fundamentals such as growth and inflation. (1) Accordingly, movements in the curve in response to economic and financial shocks are typically watched closely by market participants and policymakers. However, several recent episodes of market illiquidity, most notably the crisis in the fall of 1998, have shown that disruptions to liquidity can affect the short-term dynamics of interest rates and the shape of the curve independently of fundamentals.

In this article, we study the influence of market liquidity and dynamic trading strategies on the short-run dynamics of the yield curve. Specifically, we focus on the recent behavior of intermediate-maturity interest rates for evidence of market liquidity effects arising from the hedging of interest rate options. We base our approach in large part on the hypothesis that the hedging transactions of interest rate options dealers generate systematic trading flows in the underlying fixed-income markets following a shock to interest rates.

In the interest rate options market, dealers are net writers of options, and they manage or hedge their options exposures by taking offsetting positions in fixed-income instruments such as U.S. Treasury securities and Eurodollar futures contracts. As interest rates change, the dealers must buy or sell fixed-income securities to adjust these hedge positions. Consequently, in the aggregate, these hedging transactions can potentially affect the market prices of the hedging instruments themselves, thus leading to further changes in interest rates. Although the size of these hedging transactions in Treasuries and Eurodollar futures is usually relatively small, the transactions' systematic relationship to changes in interest rates suggests that they may still produce small but observable feedback patterns in the short-run movements of interest rates.

Our study reveals that the short-run dynamics in the intermediate maturities of the yield curve changed around 1990, with the appearance of positive feedback in weekly interest rate changes. For example, we find that after 1990, if the yield curve "bows" up at the five-year maturity, five-year interest rates are likely to rise further in subsequent weeks. The observed positive feedback is consistent with the effects of options dealers' hedging activity, and, notably, it is found only in the 1990s, after the market for interest rate options grew to a significant size. We also provide evidence indicating that the speed at which feedback effects move through the yield curve has increased in recent years. Not surprisingly, the market liquidity/positive-feedback effects are concentrated in the weeks following the largest changes in interest rates, but they are virtually nonexistent during periods of small changes in interest rates.

Our results also suggest that very short-run movements in the yield curve should be interpreted with caution, because such movements may reflect liquidity effects as well as changes in economic fundamentals. …

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