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Trading activity is often viewed as a stabilizing force in markets. The risk inherent in this activity, however, can sometimes have a destabilizing effect on the trading environment.
Author Kambhu considers how the risk associated with convergence trading affects market liquidity and asset price volatility in the interest rate swap market. He studies these issues in terms of the behavior of the interest rate swap spread—the spread between the interest rate swap and Treasury interest rates—and the volume of repurchase, or repo, contracts.
Kambhu observes that convergence trading—in which speculators trade on the expectation that asset prices will converge to their fundamental, or normal, levels—typically stabilizes markets. By countering and smoothing price shocks, these trades can enhance market liquidity. However, if convergence traders close out their positions prematurely, asset prices will tend to diverge further from their fundamental levels.
The author's results show both stabilizing and destabilizing forces in the market attributable to convergence trading:
The swap spread tends to converge to its fundamental level more slowly when the capital of traders has been weakened by trading losses, while higher trading risk can sometimes cause the spread to diverge from its fundamental level.
Although convergence trading typically absorbs shocks, an unusually large disruption can be amplified when traders close out their positions prematurely. Destabilizing shocks in the swap spread are associated with a fall in repo volume consistent with the premature closing out of convergence trading positions. Repo volume also falls in response to convergence trading losses.
Kambhu explains that taken together, these results are consistent with the argument that while convergence trading tends to be a stabilizing force, the risks in trading, as reflected in repo volume, on occasion can lead to behavior that destabilizes the swap spread.
About the Author
John Kambhu is a vice president at the Federal Reserve Bank of New York.
The views expressed in this summary are those of the author and do not necessarily reflect the position of the Federal Reserve Bank of New York or the Federal Reserve System.