Dealers’ Hedging of Interest Rate Options in the U.S. Dollar Fixed-Income Market

As derivatives markets have grown, thescope of financial intermediation hasevolved beyond credit intermediation tocover a wide variety of risks. Financialderivatives allow dealers to intermediate the risk managementneeds of their customers by unbundling customerexposures and reallocating them through the derivativesmarkets. In this way, a customer’s unwanted riskscan be traded away or hedged, while other exposuresare retained. For example, borrowers and lenders canseparate a loan’s interest rate risk from its credit riskby using an interest rate swap to pass the interest raterisk to a third party. In another example of unbundling,an option allows an investor to acquire exposureto a change in asset prices in one direction withoutincurring exposure to a move in asset prices in theopposite direction.[...]