Do market intermediaries hedge their risk exposure with derivatives?: evidence from UK Government bond dealers' spot and derivatives positions

Naik, N and Yadav, P K (2000) Do market intermediaries hedge their risk exposure with derivatives?: evidence from UK Government bond dealers' spot and derivatives positions. Working Paper. London Business School IFA Working Paper.

Abstract

Using a comprehensive dataset from the Bank of England of UK government bond dealers' spot and derivatives positions at the end of each day, we find that dealers actively hedge their spot risk with derivatives. However, they hedge selectively rather than engage in full cover hedging. Some of these dealers hedge not only their main risk factor, i.e., Duration exposure, but also the second risk factor, Twist exposure. Their decision to hedge depends on the efficiency of the hedge instrument available. Dealers hedge changes in their spot exposure to a greater extent when the bond market volatility is higher, when the level of their spot exposure is high and changing in a direction that exacerbates the magnitude of the exposure, and when the cost of hedging is lower. Overall these findings support the predictions of Stulz (1984), Stulz (1996) and Froot and Stein (1998). Finally, we find that the profits of dealers from the "view taking" implied in their selective hedging are statistically and economically indistinguishable from those that would have arisen from following a "full cover" hedging policy.