Dealers' hedging of interest rate options in the U.S. dollar fixed-income market

Despite investors' willingness to hold a variety of financial assets and risks, a significant share of interest rate options exposures remains in the hands of dealers. This concentration of risk makes the interest rate options market an ideal place to explore the effects of dealers' dynamic hedging on underlying markets. Using data from a global survey of derivatives dealers and other sources, this article estimates the potential impact of dynamic hedging by interest rate options dealers on the fixed-income market. The author finds that for short-term maturities, turnover volume in the most liquid hedging instruments is more than large enough to absorb dealers' dynamic hedges. For medium-term maturities, however, an unusually large interest rate shock could lead to hedging difficulties.Hedging (Finance) ; Options (Finance)

Why is the U.S. Treasury contemplating becoming a lender of last resort for Treasury securities?

The U.S. Treasury announced in August 2005 that it is exploring whether to provide a backstop securities lending facility for U.S. Treasury securities. This paper examines the conceptual basis for such a facility by analogizing the market for borrowing and lending Treasury securities with the market for borrowing and lending money prior to the founding of the Federal Reserve System in 1914. An inelastic supply of currency in the nineteenth century led to periodic suspensions of convertibility of bank deposits; Congress authorized a system of Federal Reserve Banks to address the problem. A similarly inelastic supply of Treasury securities has led to several recent episodes of chronic settlement fails. A backstop lending facility would mitigate the fails problem by allowing the Treasury to act as a lender of last resort of Treasury securities during periods of unusual market stress.Government securities