The Present Value

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

Foreign Exchange Swaps and Cross-currency Swaps

Swiss Finance Institute Research Paper Series
By Angelo Ranaldo

The paper explains the main characteristics of foreign exchange (FX) and cross-currency swap contracts and highlights several aspects of the FX swap market and its institutional framework.

The author reviews definitions of FX and cross-currency swaps and explains the differences in the usage of these products. FX swaps are mainly used by banks for managing short-term funding liquidity across currencies or for hedging FX risk on a rolling basis. Cross-currency swaps, on the other hand, are used for long-term hedges, such as hedging corporate bond issuances.

Using data from the Bank for International Settlements central bank survey and the continuous linked settlement system, the paper provides several insights into the key features of the FX swap market. The FX market is dominated by the US dollar, followed by the euro. In 2019, almost half of all FX trades included the US dollar and approximately 20% included the euro.

Bank-to-bank transactions accounted for 93% of FX swap volume, while bank-to-fund transactions totaled 6%. The remaining 1% included transactions between banks and non-bank financial institutions. Overnight swaps accounted for 45% of total volume and approximately 80% of the total volume was within a one-month maturity.

The FX swap market is an over-the-counter market that comprises different types of market participants, including banks, central banks, large multinational corporations, hedge funds, pension funds, mutual funds, retail clients and other institutional investors. Dealers act as market makers and liquidity providers to their customers. There is also interdealer trading that allows for the adjustment of inventory imbalances and hedging positions.

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Links Between Government Bond and Futures Markets: Dealer-client Relationships and Price Discovery in the UK

Bank of England Staff Working Paper
By Domenico Di Gangi, Vladimir Lazarov, Aakash Mankodi and Laura Silvestri

The study examines trading and clearing relationships between dealers and clients in the UK gilt cash and futures markets. The analysis is based on transaction-level data from January 2016 to November 2016, which is the period covering the significant price moves around the EU referendum and subsequent policy announcements.

Gilts are UK government bonds that are traded over the counter through designated market makers known as gilt-edged market makers (GEMMs). Gilt futures are traded on exchanges using a central limit order book and cleared through a central counterparty (CCP).

The analysis shows that in both cash and futures markets, clients rely on a small number of dealers. On average, clients trade with one or two GEMMs and use a single clearing member on a daily basis.

If firms that are both GEMMs and clearing members were unable to perform their roles, the large share of clearing and trading activity would be impacted. On average, the removal of the top three GEMMs and clearing members leads to a reduction of approximately 30% and 80% of the volume in gilt cash and futures, respectively.

The authors also analyze the price discovery between the two markets and show that client order flows in the gilt futures market can affect gilt cash prices. For example, order flows from hedge funds in the futures market increase gilt cash prices, while order flows from asset managers, insurance companies and pension funds decrease gilt cash prices.

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Illiquid Bitcoin Options

By Yang Guo, Jiasun Li, Mei Luo and Yintian Wang

This study examines the bitcoin options market in the US, which is approved by the Commodity Futures Trading Commission. The analysis is based on transaction data from LedgerX exchange.

The study finds that bitcoin options are highly illiquid, as demonstrated by an extremely high bid-ask spread. Average bitcoin option spreads are almost 10 times higher compared to stock options, which have an average spread of 7-8% of the mid-quote price. The heightened illiquidity of bitcoin options is associated with a significant premium in subsequent delta-hedged returns.

The authors analyze whether designated liquidity providers are on average buying or selling bitcoin options. They find there are significantly more sell-initiated option trades than buy-initiated ones. As designated liquidity providers simultaneously post bid and ask prices and investors take liquidity by initiating trades in response to provided quotes, this finding suggests that designated liquidity providers on average have long positions in bitcoin options.

The analysis also covers the impact of a policy change that allowed retail investors to participate in the bitcoin option market. This policy resulted in a significant change in the composition of option market participants and shifted the market from a sell-initiated state to a more balanced one.

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