THE EFFECT OF DYNAMIC HEDGING OF OPTIONS POSITIONS ON INTERMEDIATE-MATURITY INTEREST RATES
Thanasis N. Christodoulopoulos
Bank of Greece, Monetary Policy & Banking Department
Ioulia Grigoratou
Bank of Greece, Monetary Policy & Banking Department
ABSTRACT
When interest rates change, interest rate options dealers buy or sell securities to adjust the hedging positions that they have taken in order to offset their options exposures. The net result of this trading activity, which is unrelated to economic fundamentals, can be to push interest rates further in the direction they were moving. Such “feedback” effects interfere with the short-term dynamics of interest rate movements and can alter the shape of the yield curve, especially when changes in interest rates are large. Our empirical results confirm the existence of a positive feedback from the activity in the euro-denominated interest rate options market to the european yield curve. This finding can be useful for risk management purposes but also for analysts and policy makers when interpreting short-run movements in the yield curve as signals of future economic activity.
Keywords: Interest rate options; Dynamic hedging; European yield curve
JEL classification: E43; G130; G110; G140;
The authors wish to thank Heather Gibson, Nikos Zonzilos and Stephen Hall for helpful comments. We are also grateful for their comments to our colleagues-members of the Markets Monitoring Working Group of the ECB where the paper was first presented. The views expressed are those of the authors and do not necessarily reflect the position of the Bank of Greece or the Eurosystem.
Th. Christodoulopoulos,
Monetary Policy & Banking Department,
Bank of Greece, 21 E. Venizelos Av.,
102 50 Athens, Greece,
Tel. + 30 210 3202482
Email: tchristodoulopoulos@bankofgreece.gr