The effect of interest rate options hedging on term-structure dynamics

Market participants and policymakers closely monitor movements in the yield curve for information about future economic fundamentals. In several recent episodes, however, disruptions to market liquidity have affected the short-term dynamics of the curve independently of fundamentals. This article provides evidence that the short-run dynamics in the intermediate maturities of the yield curve changed around 1990, with the appearance of positive feedback in weekly interest rate changes. The feedback is consistent with the effects of options dealers’ hedging activity and it is found only in the 1990s, after the interest rate options market grew to significant size. The authors also show that the market liquidity/positive-feedback effects are concentrated in the weeks after the largest interest rate changes. Their results suggest that the times when market participants and policymakers are most interested in extracting from the yield curve a signal about economic fundamentals are precisely the times when changes in the curve may be distorted by liquidity effects.