The Present Value

ISDA highlights a selection of research papers on derivatives and risk management         


OTC Microstructure in a Period of Stress: a Multi‑layered Network Approach

Bank of England Staff Working Paper No. 832
By Andreas Joseph, Michalis Vasios, Olga Maizels, Ujwal Shreyas and John Tanner

This paper analyzes the microstructure of the foreign exchange over-the-counter (OTC) derivatives market during a period of stress triggered by the Swiss National Bank (SNB) announcement that it was discontinuing the minimum swiss franc-euro exchange rate on January 15, 2015.

The study establishes a multi-layered structure of counterparties by dividing market participants into three segments: the inner dealer core, the outer core and peripheral clients. The inner dealer core consists of 15 large and well-connected dealer banks accounting for more than 90% of the market. The outer core includes banks, corporates and hedge funds that trade frequently and are connected with multiple inner core dealers, but they do not interact with other outer core firms or the periphery market participants. Peripheral clients, which include the largest number of market participants, are smaller banks, real money investors and corporates that only have a single connection going in either direction and exclusively rely on the inner dealer core for sourcing liquidity.

The study demonstrates that the impact of the SNB announcement was not homogeneous for different market segments. In response to the announcement, there was limited interdealer liquidity. In the first 20 minutes, trading was mostly performed by the outer core clients entering the market. After this initial phase, the inner dealer core become active, coinciding with the price reversal of the Swiss franc and eventual price stabilization. The periphery was relatively inactive until the price stabilized.

One of policy implications mentioned in the study is that more transparency and more centralized trading could play a positive role by making markets more efficient.

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The Relationship between Announcements of Complete Mergers and Acquisitions and Acquirers’ Abnormal CDS Spread Changes

University of Paderborn
By Benjamin Hippert

The study analyzes the impact of mergers and acquisitions (M&A) activity announcements on the risk perception of investors that hold credit default swaps (CDS) written on acquiring firms. The study uses the sample of 492 complete M&A transactions from 284 acquirers across North America and Europe between 2005 and 2018, and focuses on abnormal CDS spread changes due to M&A announcements.

The analysis reveals that acquiring firms exhibit positive abnormal CDS spread changes of about 310 basis points during a five-day event window due to the announcement of a complete M&A transaction. This finding suggests that CDS investors perceive an increase in the acquirer’s credit risk exposure immediately after the announcement has taken place. The effect of the announcement is not immediately and completely perceived by CDS investors, and can be observed during the next two trading days.

The study finds that CDS investors view mergers as more risky compared to acquisitions of assets through tender offers. Additionally, M&A announcements of more complex deals are perceived as more risky compared to simpler transactions. Likewise, CDS investors of acquiring firms perceive M&A announcements as more risky if leverage ratios rise as a result of a debt-financed M&A transaction or when acquirers purchase target firms with higher market-to-book values due to possible overpayment incentives of acquirers.

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What Drives the Short-Term Fluctuations of Banks’ Exposure to Interest Rate Risk?

Deutsche Bundesbank Discussion Paper
By Christoph Memmel

The study analyzes the short-term fluctuations in bank exposures to interest rate risk. This analysis is performed based on the data from German banks during the period between the fourth quarter of 2011 and the second quarter of 2017.

The paper demonstrates that banks actively manage their interest rate risk exposure in the short run (for example, with interest rate swaps). Banks consider their regulatory situation when they adjust their interest rate risk, and they increase their exposure to interest rate risk when its remuneration increases.

The study examines how customer preferences for interest rate risk influence the bank’s exposure to this risk. The author finds that the fixed interest period of housing loans is predominantly determined by customers (and not banks), and the overall exposure of a bank to interest rate risk rises when the fixed interest period of its new housing loans increases.

This finding is not in line with active interest rate risk management. The study points out that there is still a connection between the granting of housing loans and a bank’s overall exposure to interest rate risk, and suggests that banks offset only 11.4% of those changes in interest rate risk exposure that result from the housing loan business within one quarter.

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