The Effect of Dynamic Hedging of Options Positions on Intermediate-Maturity Interest Rates

Thanasis Christodoulopoulos () and Ioulia Grigoratou
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Thanasis Christodoulopoulos: Bank of Greece, Monetary Policy & Banking Department
Ioulia Grigoratou: Bank of Greece, Monetary Policy & Banking Department

No 8, Working Papers from Bank of Greece

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 (search for similar items in EconPapers)
JEL-codes: E43 G11 G13 G14 (search for similar items in EconPapers)
Pages: 32 pages
Date: 2003-12
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Citations: View citations in EconPapers (5)

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